A Primer on ESG Investing

January 23rd, 2020

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As more people embrace the idea of socially responsible investing, Environmental, Social and Governance (ESG) funds have grown tremendously. “Value investing” takes on a different meaning for ESG proponents, as they want their investments to reflect their values.

In this article, we will provide a brief primer on ESG investing. Later this month, we’ll follow up by providing additional analysis on specific ESG ETFs.

Inclusion, Evolution, and the History of ESG Funds

ESG investing has become more prominent in recent years. With that said, these funds have existed for decades. Before, funds might consider themselves socially responsible if they avoided certain industries like tobacco or energy. Investors are now seeking funds that are proactive on the activities of a company and how they meet ESG standards.

The bottom line for inclusion in an ESG fund is that money going into projects cannot have negative consequences. However, this is not a perfect world, and individual investors must decide whether a fund’s ESG strategy complements their own or if they require more stringent inclusion criteria.

Today, investors are looking for funds that satisfy all three components of ESG investing - environmental, social, and governance. We explore each component throughout the remainder of this article.

Environmental Criteria

Environmental criteria for ESG funds usually includes consideration of a company’s general and specific environmental actions and activities, such as:

  • Climate change policies and ways to address it
  • Energy and natural resource use, including renewables
  • Environmental regulation compliance
  • Green technologies
  • Fossil fuel production or use
  • Commercial logging in tropical forests
  • Conservation efforts
  • Pollution
  • Sustainability
  • Treatment of animals
  • Waste production

Social Criteria

The social criteria for inclusion focuses on workplace practices and company culture, including:

  • Consumer protection
  • Employee turnover
  • Ethical supply sourcing
  • Human rights support
  • No forced or child labor
  • Sexual harassment prevention
  • Social justice issues stance
  • Support of local communities
  • Volunteerism
  • Worker treatment
  • Workplace diversity

Many investors want to see a formal ESG mission statement for a company, and how it intends to fulfill its stated goals and higher purpose.

Governance Criteria

When it comes to governance, the main criteria is the way a company is run, with an emphasis on leadership and business conduct and ethics. Such considerations may involve:

  • Board member conflict of interest
  • Crisis management
  • Data security
  • Employee relations
  • Employee compensation
  • Executive pay
  • No history of illegal conduct
  • No or limited political contributions
  • No workplace discrimination
  • Tax strategies
  • Transparent accounting methods

Exclusion Criteria

Just as critical as inclusion criteria are the industries that many ESG funds will not touch. ESG investors have their personal criteria as to what industries are acceptable. So do individual ESG funds.

In 2018, BlackRock, the world’s largest asset manager, announced it would not invest in companies manufacturing or selling firearms for civilians. While that hardly makes BlackRock an ESG firm, it does show that ESG principles are increasingly becoming mainstream. At the time of its announcement, it became clear that BlackRock’s list of unacceptable companies included Walmart, Dick’s Sporting Goods and Kroger, besides more obvious brands such as Ruger.

Here are some commonly excluded investments for ESG funds, i.e., “the classics,” but as noted, they are not universal:

  • Alcoholic beverages – beer and wine are often excepted
  • Casinos and other gambling ventures
  • Internationally banned herbicides and pesticides
  • Pornography
  • Tobacco production or trading
  • Weapons and munitions trading

Sacrificing Returns for Values

It is a given for many ESG investors that they will sacrifice some returns in exchange for putting their funds in socially responsible endeavors. After all, if a substantial number of companies are off-limits for investment consideration, that should affect profit potential.

While whether returns are sacrificed by responsible investing is still debatable, it is apparent that some companies that do not follow ESG practices have performed poorly in recent years. When “Emissionsgate” struck Volkswagen, affecting nearly 500,000 cars sold in the U.S., the company’s stock price plummeted and it faced billions in fines and other losses.

Risk Management

One benefit of ESG funds that by their nature does not apply to conventional financial metrics is that of reducing risk. Risk reduction also does not happen by accident. Companies that successfully reduce investor risk usually have first-rate management teams.

Climate change is perhaps the best example of future risk management needs. It is becoming increasingly obvious that without action on climate change, entire economies and regions may face devastation in the near future. Natural disasters will continue to rise on an unprecedented scale. ESG investing may prove more than socially acceptable. It may end up as a primary method for saving the planet, as people increasingly put their money where their ethics lie.

Final Thoughts

ESG investing is a rapidly-developing field within the investment management industry. Its principles are sound and it is gaining increasing adoption worldwide. According to a widely-circulated 2018 survey, approximately one-quarter of U.S. assets under management are now benchmarked to ESG strategies.

If you’re interested in implementing ESG principles within your self-directed portfolio, try Passiv Community for free today and automate your portfolio management in your brokerage account.

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