What is ESG-Focused Investing?

By VWG Wealth Management on April 7, 2021

The term ESG has gained a lot of attention and momentum over the past few years.  ESG – Environmental, Social, Governance – is a term that has become interchangeable with sustainable investing, socially responsible investing, or impact investing.  ESG-focused investing is broadly defined as evaluating metrics of environmental, social and (corporate) governance factors, alongside traditional financial analysis.  ESG can mean different things to different people, allowing investors to direct their investments in support of their ideals related to these issues.

ESG investing has evolved to meet three common investor objectives:

1) Filtering – Many investors believe ESG factors can potentially be used to identify better-managed companies that hold higher ethical standards, or to flag companies with business practices and products that are likely to face headwinds from rapidly changing macro trends.

2) Alignment of Values – A greater number of clients are choosing to align their investments with their personal beliefs.  For example, businesses operating in tobacco, weapons, gambling, or alcohol might be excluded.  Businesses emphasizing values aligning with that of the investors would be featured.   These could include environmental sustainability, community involvement or women representation in corporate leadership.

3) Positive Impact –Investors increasingly are seeking to create positive impact that provide solutions to environmental and social challenges.

As this graphic shows, ESG-focused investing is just one point along the spectrum of the placement and allocation of ethical / sustainable / impact / philanthropic assets.

Attention to ESG Investing is Growing

The last few years have seen accelerating growth in the interest of ESG investing.   According to Morningstar, flows into ESG funds totaled $21.4 billion in 2019, a nearly fourfold increase from the previous year.  Interest has been evident in both investor demand and asset manager offerings.  While many factors have contributed to this growth, we see three primary drivers of ESG focus:

• The world is changing – Global sustainability challenges such as severe weather changes and rising sea levels, privacy and data security, demographic shifts, and regulatory pressures, are introducing new risk factors for investors. As companies face rising complexity on a global scale, traditional investment analysis may need to be reevaluated.
• Investors are changing – Studies conducted by Fidelity Investments and the CFA Institute suggest that a growing body of investors are asking more of their investments. These trends have accelerated over the past few years across all age demographics and many experts believe that the COVID-19 pandemic will only further accelerate these trends.
• Data and analytics are evolving – Better corporate data combined with better ESG research and analytics is leading to improved quantitative, object and financially relevant approaches to ESG key issues. Better data and analytics are paving the way for numerous studies that explore ESG investing which should lead to standardized ESG reporting.

Refuting Common ESG Myths

The greatest misconception regarding sustainable or ESG investing is that investors must give up performance as a ‘trade off’ for ethical alignment.  This does not have to be the case. There are many studies comparing ESG investing with traditional investing that show long-term historical performance is very comparable.  Another misconception is that the rise of ESG-focused investing has been driven by younger investors.  In fact, investors interested in ESG strategies has grown the fastest in the 65+ cohort over the past three years according to a study conducted by the CFA institute.

The ESG label itself may lead to some misconceptions.  Currently, there are no universally accepted ESG reporting standards for businesses.  Significant differences of opinions exist among institutions and index providers over the criteria needed for a business to be deemed ‘ESG approved.’  The Wall Street Journal has noted the practice of ‘greenwashing,’ when investment firms give misleading claims about their products or ESG credentials.  A deeper dive into some ESG-labeled products often reveals that only one of the ‘E,’ ‘S,’ or particularly ‘G’ criteria are emphasized.

The concept of ESG investing can at times become confused with other activities along the spectrum of responsible, purpose-based investing.  This is illustrated in the above graphic, showing some overlap of actions and desired outcomes.  We advocate trying to align our values in all things we do, including investing.   We would like to believe that the identification and promotion of quality businesses following a high level of ethical and sustainability conduct will lead to others upping their game, creating a virtuous cycle from which we and future generations will benefit.  However, this does not mean that ESG investing should be considered as a substitute for impact investing or philanthropic activities, which are more directly attempting to affect change.