Pros And Cons Of ESG Investing

In today’s world, a company’s bottom line doesn’t always mean its profit or loss for the year. Increasingly, investors are demanding that companies measure and improve their environmental and social impact along with their financial performance. 

Triple bottom line investors care about people, the planet, and profits. If you’re interested in doing well by doing good, you may want to consider ESG investing. The acronym stands for environmental, social, and governance. 

Global ESG assets may surpass $41 trillion by 2022 and $50 trillion by 2025. If you’re considering ESG investing, first understand the pros and cons beforehand.

Invest for the Future You Want

Investing in environmentally and socially conscious companies isn’t merely about avoiding harm. Publicly-traded ESG companies have the scale and resources that can allow them to create a pro-social future. 

These companies may positively influence the international corporate scene, or they may produce products and services that positively serve humanity. 

Build a Portfolio That Will Keep You Invested in Tough Times

Overtrading can be hazardous to wealth. Many investing thought leaders have cited a study that Fidelity’s best investors are dead because they can’t overtrade. The study appears to be debatable, but its point remains. Common investors do best when they buy and hold over the long run.

But sticking with a portfolio allocation can be tough. Investors use all kinds of heuristics to avoid eroding their wealth through common mistakes. Some never look at their portfolio. Others dedicate a small portion of their money to “Vegas money.” 

If ESG investors believe that their portfolio is bringing positive social effects, they may be more likely to stay invested in the long run. They won’t have as much incentive to chase the hot new stock because it needs to fit into their socially curated portfolio.

ESG Investing May Produce Returns on Par with Traditional Investing

Investors may worry that ESG investing will produce suboptimal outcomes, but there is evidence that ESG investing may be as profitable as passive investing. According to a 2019 white paper by the Morgan Stanley Institute for Sustainable Investing, a comparison of 11,000 funds (including several hundred ESG funds) showed no financial disadvantage of investing in ESG funds. The paper accounted for returns, net of fees, which means that expenses were taken out of total returns. The paper not only analyzed total returns but volatility as well.

Of course, past performance doesn’t guarantee future results. And over and underperformance may fluctuate depending on the economic cycle. For example, many ESG companies may underperform during energy stock booms. However, you may be able to weather these storms and see strong performance in your ESG portfolio.

You May Pay a ‘Greenium’

Fees and expenses are the enemies of performance returns, and ESG funds tend to carry higher than average expense ratios, according to Morningstar’s 2020 U.S. Fund Fee study. This Greenium may lead to some underperformance, especially compared to the very low expenses that index fund investors have to pay.

Of course, you may be happy to pay a premium to a fund manager who actively researches ESG factors to keep the fund on track with your values.

You Have to Pick Your Issues

No company can lead across every ESG dimension. Some promote women in leadership positions, others reduce pollution and carbon emissions. Others avoid cronyism and other misbehaviors that threaten democratic ideals at home and abroad. Few companies do everything well. And most companies choose to report their most impressive records.

Even if clear metrics for ESG efforts existed (which they don’t), investors would still have to choose the issues they care about. For example, oil companies extract and burn fossil fuels, but they are also heavily invested in renewable energy research and development. Even more dubiously, agricultural companies produce food that feeds the planet and lifts millions of farmers out of poverty, but they may be polluters or engaging in unsustainable environmental practices.

One company may have a strong record of women in leadership positions, but over index on polluting and carbon emission activities. Another may have a strong environmental record but have poor employee-management relationships. 

When vetting an ESG fund or platform, make sure that you understand which issues are most important to the fund manager. If those values align with yours, then the fund or the platform may make sense for you.

No Clear Environmental, Social, or Governance Standards

The Securities and Exchange Commission (SEC) regulates reporting for publicly traded companies. While the SEC requires companies to report certain metrics, its governance of ESG metrics is loose. As a result, every company manages its own ESG reporting.

An external agency, International Sustainability Standards Board (ISSB) is slowly working towards setting international environmental standards, but this work is slow. Today, investors must depend on company-defined and reported metrics. In some cases, these may be credible sources of information, but they may gloss over some poor business practices.

You either need to trust your fund manager to dig into these metrics for you, or you’ll need to spend a lot of time researching individual companies to add to your portfolio.

You May Become Underdiversified

As an ESG investor, you aren’t precluded from investing in any sector of the economy, but you run the risk of becoming under diversified due to your ESG standards. For example, a person who requires a strong track record of women and minorities in leadership positions would find very few large U.S. stocks in their portfolio.

If you don’t actively seek out energy alternatives, you’re likely to miss out on this important sector. Figuring out an appropriate asset allocation becomes very important if you’re an ESG. Using a portfolio analysis tool may be critical to keeping your portfolio on track.

Does ESG Investing Make Sense for You?

There are hundreds of ESG mutual funds available. Robo-advisors like Betterment and Wealthfront offer ESG options for investors seeking passive options. Take a look at the table below for a quick comparison. 

Only you can decide whether to include environmental, social, and governance factors in your portfolio. If you decide to use those factors in your portfolio, you need to choose which issues are most important to you and select your portfolio based on those criteria (and profitability).