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The Pros & Cons of ESG Investing

October 24, 2022
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If you haven’t heard much about ESG investing, you will. ESG has gone from a niche investment philosophy to a mainstream investment tenant. At the same time, it has gained the attention of corporations, politicians, regulators, and investors.

ESG stands for environmental, social, and governance and is a way of investing in companies based on their commitment to one or more of these ESG factors. While the ESG acronym was first used in 2005, the concept has been around a lot longer. You may also know it as sustainable investing, socially responsible investing, or impact investing.1

This type of investing has grown exponentially, especially over the past few years. Morgan Stanley reports that more than $1 of every $4 under professional management globally is invested sustainably. What’s more, 84% of investors are at least “actively considering” adding some socially conscious investing to their portfolios.2

According to Morningstar, there are now more than 550 ESG investment choices available to U.S. investors — more than double the number from just five years ago.3

As of December 2021, assets under management at funds with ESG investment objectives reached more than $2.7 trillion. In the fourth quarter of 2021 alone, $143 billion in new capital flowed into these ESG funds. As you can imagine, this has major implications for the market.4

Keep in mind that Socially Responsible Investing (SRI) / Environmental Social Governance (ESG) investing has certain risks based on the fact that the criteria exclude securities of certain issuers for non-financial reasons and, therefore, investors may forgo some market opportunities and the universe of investments available will be smaller.

What makes up ESG?

The environmental factor, or the “E” in ESG, focuses on a company’s impact on the environment or the risks and opportunities associated with climate change on the company, its business model, suppliers, and industry. A major part of ESG growth has been driven by the attention to this environmental component, as companies look to move away from fossil fuels, reduce their carbon footprints, and become more sustainable in their operations.

The ”S” is the social factor. This aspect of ESG revolves around a company’s relationship with people and society, including whether the company invests in its community. The social dimension of a company has been gaining prominence as management and boards spend an increasing amount of time on issues such as diversity and inclusion, both inside and outside the company.

Governance is the “G” and looks at issues such as the inner workings of how the company is run, its treatment of shareholders, executive compensation, and the composition of its board of directors.

ESG isn’t one-size-fits-all

ESG investing isn’t exactly straightforward. There are currently no uniform standards for determining a company’s ESG rating. ESG funds each use different criteria to define their investment strategies and rely on the unregulated and unaudited ESG self-reporting of the corporations that make up their portfolios.

The SEC proposed rules on ESG in March of 2022 to make ESG reporting more uniform. These proposed rules would establish new disclosure and reporting requirements related to ESG factors while refining ESG-related fund naming requirements to avoid misleading investors.5

There has been pushback from various industry groups and lawmakers to the SEC's proposed ESG regulations. Many of these critics believe that businesses are getting too involved in cultural and political fights and that the federal government shouldn’t be building ESG principles into regulations. This means that implementation of the new SEC guidance in its current form is not guaranteed.

Should ESG be part of your investment strategy?

Deciding on whether to make ESG investing part of your long-term financial strategy depends on your goals.

If your goals go beyond absolute returns and include using your investment dollars to impact the world around you, then maybe you should consider ESG as a factor in your overall portfolio construction.

The case for ESG investing

  • Influencing positive changes in society: Some investors gain satisfaction in knowing that their money is going to support companies that share their values. This provides a positive personal return, even if it’s not necessarily a financial one.
  • Better long-term performance potential: Those who advocate ESG investing believe that socially responsible and environmentally sustainable companies will outlast companies that do not share those principles. The thinking is that non-ESG-focused companies are taking risks that can hurt them over time, therefore also hurting those who invest in them. In the long run, the sustainability-conscious investor may reap greater financial benefits.
  • Less inherent risk potential: Companies that focus on ESG tend to have above-average risk control and compliance standards. Because of this, highly rated ESG companies may have less severe incidents of fraud, embezzlement, corruption, or litigation that can crush the value and reputation of a company. Fewer risk incidents can ultimately lead to less stock price downside.
  • Growing market: According to a June 2022 Bank of America study, ESG investing could rise by $15 trillion to $20 trillion over the next decade. This results in a self-fulfilling prophecy – as ESG becomes more mainstream, money will flow to these companies, increasing their stock prices over time. Changing investor demographics are expected to drive this growth as women, millennials, and GenZers are seen as more likely to build their portfolios around stocks that measure up to ESG metrics.

The case against ESG investing

  • Different values: Social responsibility and values investing sound like a noble idea but are subjective. There is no guarantee that a company or fund with a high ESG rating is actually in alignment with your values and views on any number of topics that are personally meaningful.
  • Poorer performance: In an August 2019 Journal of Finance paper, University of Chicago researchers analyzed the Morningstar sustainability ratings of more than 20,000 investment choices representing over $8 trillion of investor savings. The analysis showed that none of the high sustainability-rated funds outperformed any of the lowest ESG-rated funds.
  • Some companies don’t live up to their promise: In April 2021, Researchers at Columbia University and the London School of Economics compared the ESG record of U.S. companies in 147 ESG fund portfolios to that of U.S. companies in 2,428 non-ESG portfolios. Surprisingly, the research showed that the companies in the ESG portfolios had worse compliance records when it came to labor and environmental issues. They also found that even after companies were added to an ESG portfolio, they did not improve their labor or environmental records.
  • Diverting from poor corporate results: There’s evidence that companies may publicly embrace ESG as a way of diverting attention away from poor business performance. Research has shown that when a firm underperformed earnings expectations, it often publicly talked about its focus on ESG. But when they exceeded expectations, they made few, if any, public ESG remarks. This could lead to sustainable fund managers, who direct investments to companies publicly embracing ESG principles, investing in underperforming companies.

Talk with a financial professional

As you can see, there are a number of reasons you may want to consider ESG investing, as well as some factors that should make you skeptical.

If you would like to learn more about ESG investing and the features, benefits, and risks of this market segment, please give us a call and we can set up a time to discuss. We have a number of resources in our office that help you better understand ESG investing.

1. Forbes.com, 2019
2. HBR.org, 2022
3. McKinsey.com, 2022
4. NYTimes.com, 2022
5. SeekingAlpha.com, 2020

The content is developed from sources believed to be providing accurate information. This material was developed and produced by FMG Suite to provide information on a topic that may be of interest. FMG Suite, LLC, is not affiliated with the named representative, broker-dealer, state- or SEC-registered investment advisory firm. The opinions expressed and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security.