Over the past few years, you might have heard of environmental, social, and governance (ESG) investing but remain unsure of exactly what it is.
ESG investing involves considering a set of ethical guidelines or standards when deciding which companies to invest in. ESG investing takes three core pillars into account:
- The environmental credentials of a company
- A company’s social impact
- A firm’s corporate governance.
It has become an increasingly popular way of investing as individuals push for greater control over how their investments align with their own personal beliefs and values.
However, like any area still in its relative infancy, there remains a lot of debate surrounding the potential benefits of ESG investing.
Read on to discover what defines an ESG investment, three useful benefits of investing in one, and a few potential downsides to consider.
ESG guidelines help investors determine whether a company is acting responsibly
ESG investing relies on non-financial factors to help guide investors. It involves considering a company or fund you are thinking of investing in across a range of criteria other than simply performance.
The three core pillars cover:
- Environmental factors that focus on conservation and sustainability efforts
- Social factors that determine how a company treats its employees, consumers, and the wider community
- Governance factors that consider how ethically a company operates at boardroom level.
An ESG fund or ESG-compliant company will typically possess an “ESG rating”, which will be provided through an audit by an external agency. These agencies will look at a range of issues across the three central pillars, including those in the table below:
These guidelines can help encourage corporations to adopt ethical and environmental policies and to act more responsibly.
It is now possible to seek out a wide range of investments that fit ESG criteria.
So, aside from the benefit of aligning your investments with your core values, why might you want to consider ESG investments?
3 useful benefits of ESG investing
1. You might be able to build a portfolio that could compete with traditional funds, while matching your values
ESG funds have had a strong start to 2023, with Reuters reporting that investors have added more cash to ESG funds than they have withdrawn in the year so far.
In the past, there were some doubts about whether ESG investing could provide the same kind of results for investors as traditional funds. Yet, data has shown that ESG funds have the ability to compete with or even surpass the performance of more traditional investments.
- Yodelar reports that ESG funds outperformed traditional funds across global markets by an average of 65% in the year to November 2022.
- Morningstar reports that ESG investments outperformed non-ESG funds over a five-year period between 2017 and 2021, with 57% of ESG equity funds beating their category index. They also found that, over a three-year period, 63% of ESG equity funds outperformed their category index.
- In October 2022, PwC revealed 90% of assets managers believe integrating ESG investments into their strategy could improve overall returns. Meanwhile, 60% reported that ESG investing has already resulted in better returns compared to their non-ESG equivalents.
So, it might be possible to invest with your values firmly front and centre and still see returns that match or even outperform more traditional investments.
2. You might avoid the repercussions if a firm’s value is rocked by their unethical actions
Investing in an ESG-compliant company might help you reduce some potential exposure to risk as ESG criteria encourage firms to act in an ethical manner. Companies that skirt these standards and are eventually held accountable for unethical actions could face serious financial repercussions.
A few recent examples include:
- BP’s 2010 Gulf of Mexico oil spill
- Volkswagen’s emissions scandal
- Lehman Brothers and their involvement in the subprime mortgage crisis
- The Valeant Pharmaceuticals price-gouging scandal.
In these cases, the businesses saw their respective stock prices rocked by the scandals, costing investors billions.
In choosing to invest in ESG funds, you are likely to reduce your exposure to this kind of fallout, which may leave the value of your portfolio better protected over the long term.
3. You may be more likely to stick it out with your investment and take a “passive” investing approach
Simply put, if you believe in the companies you’re investing in and are confident they align with your values, you are much less likely to want to part with your investment or second-guess your decision.
This could allow you to take on a “passive” or “buy-and-hold” approach to your investment. In turn, this may greatly decrease the costs typically associated with an active investing approach and free up valuable time to focus on other areas of your plan.
Keep in mind the potential downsides
ESG investing could potentially be a great way of generating growth on your investments while staying true to your closely held beliefs. However, there are a few downsides to consider.
Firstly, ESG investing is still a relatively new area. So, unfortunately, it lacks some of the structure and firm regulation that other approaches to investing might have gained over time.
ESG investing currently suffers from an ill-defined set of unified standards with many global agencies differing on how they define “ESG” and how they determine a firm or fund’s rating.
This ambiguity has helped unscrupulous firms take advantage of the situation and “greenwash” their businesses – presenting as an ESG-friendly company without actually adhering to the standards.
It could mean you end up investing in a company that you believe holds your values in mind, but is actually acting in bad faith.
Many major industries aren’t ESG-compliant, so investing in ESG might see you limit your options
A lot of major industries by their very nature aren’t ESG-compliant. Areas such as fossil fuels, tobacco, or the weapons industry would typically struggle to comply with ESG standards, but could generate sizeable growth for investors.
Adopting an ESG-compliant investing strategy could see you limit your options and restrict the diversification of your portfolio, while missing out on potentially beneficial gains from these sectors.
It is important to take the time to consider all the pros and cons before deciding on the right approach for you.
It is ultimately about your own personal goals
If promoting social or environmental change is vital to you, you are likely to see a benefit from ESG investing before any investment performance is considered. Anything extra will likely be a bonus to you.
It all depends on your personal goals and priorities. If you want your investments to align with your values, ESG funds could be the key.
It is important to discuss your options and receive sound advice. A good first step could be to reach out to us by email at email@example.com or call 0117 9303510.
This article is no substitute for financial advice and should not be treated as such. To determine the best course of action for your individual circumstances, please contact us.
The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.