ESG investing — “ESG” stands for environmental, social, and governance — could fundamentally change the way Wall Street operates. Some would argue it already has.
Sometimes used interchangeably with terms like socially responsible investing (SRI) and impact investing, the term ESG refers to a somewhat self-explanatory but still profound concept: buying into companies with responsible policies and a positive impact on the environment and their communities, while also having a corporate structure that’s fair for both stakeholders and shareholders.
While ESG-style investing is catching on, as it grows it also faces pushback, more scrutiny and some growing pains. Here’s what you need to know about ESG investing, why it’s on the rise, and some of the biggest challenges in the field today.
[See: These 7 Funds Make You Feel Good About Investing.]
ESG investing: demand and growth. The ESG/SRI field is growing, and the reason for that, unquestionably, is increasing client demand.
“Our clients demand and deserve a socially responsible strategy that is diverse from both a sector and geographic standpoint, and millennials are leading the socially responsible charge,” says Mitchell Wonboy, co-founder of Strategic Growth Investment Management, an SEC-registered investment advisor that only charges clients fees if they beat the market.
The numbers back up Wonboy’s observation. In 2015, Morgan Stanley did a “Sustainable Signals” report, taking the pulse of the impact investing landscape and polling investors about aspects of the area they found most important.
Twenty-eight percent of millennials said they were “very interested” in sustainable investing compared to just 19 percent of the overall population. Two years later, in 2017, Morgan Stanley took the numbers again. This time, 86 percent of millennials were interested in sustainable investing, including 38 percent who were “very interested.”
Does ESG investing hurt financial returns? The problem with this question — which gets at the heart of one of the biggest original debates in the field itself — is that ESG and SRI can mean different things to different people.
“For instance, some people believe that firms that produce birth control pills would be socially responsible while others might characterize that as irresponsible,” says Robert Johnson, president and chief executive officer of the American College of Financial Services in Bryn Mawr, Pennsylvania.
Nonetheless, “studies have shown that, in general, the returns to socially responsible investing aren’t materially higher or lower than average investment returns,” Johnson says.
Some Wall Street critics of ESG investing have cynically asserted that even if investing for good might be a growing trend, it involves a sacrifice: You can invest to make a positive change, but you should expect lower returns. Pick one or the other, you can’t have both, the thinking goes.
Turns out, that’s a false choice.
In a 2013 study by German academics Gregor Dorfleitner, Sebastian Utz and Maximilian Wimmer called, “Where and When Does It Pay to Be Good? A Global Long-Term Analysis of ESG Investing,” the authors found the opposite was true.
“We find evidence on the fact that European and North American stock portfolios with high E, S, and G scores show a significant financial outperformance in the long run — with the exception of the combination of governance and Europe,” says the 2013 study.
“Investing in the top stocks and shorting those with low E, S, G scores implies even higher abnormal returns for the investor,” it concluded.
The German academics even “observed abnormal buy-and-hold returns of up to 20 percent over an investment period of five years” in these companies with high ESG scores.
I understand measuring financial returns; how do you measure ESG return? It’s great news that socially responsible portfolios aren’t doomed to underperform, but now there’s another sticky issue to resolve: How do you measure the non-financial success of your portfolio? How can you determine its “impact”?
It’s not as simple as comparing your portfolio’s returns to an index.
Geeta B. Aiyer is president and founder of Boston Common Asset Management, an active investment manager with a focus on both financial return and social change. The firm routinely chronicles and reports its efforts to change portfolio companies’ products, processes and policies.
[Read: 5 of the Best Stocks to Buy for April.]
“This shows the meaningful change that has come about due to our tenacious, active ownership and stewardship,” Aiyer says. “We also measure and report on some ESG process profiles of our portfolios.”
For example, the firm lists things like the carbon footprint and board diversity of its portfolio companies versus the index.
Taxonomy: Which stocks are SRI or ESG-compliant? With the debate on financial return settled and the issue of measuring social impact improving, one issue still looms large over the field in general, regardless of what you want to call it: How does a fund, a money manager, rating agency, or an individual determine which companies are “good” as far as governance, society or the environment?
This was a big question five years ago, and remains so today. But there are a few qualities most in the industry agree on: Weapons manufacturers, gambling enterprises, other “sin stocks” like tobacco companies and alcohol distributors, and companies that commit severe or frequent environmental transgressions are generally ineligible.
Still, it’s a perfectly imperfect system, and standards can differ greatly from investor to investor or from fund to fund.
The iShares MSCI KLD 400 Social ETF (ticker: DSI), the largest socially responsible ETF by assets under management with roughly $1 billion, holds as its second-largest holding Facebook ( FB).
One wonders how many DSI shareholders are happy with that fact in light of the Cambridge Analytica scandal. After all, the data of 50 million users was improperly accessed, and the breach ultimately could’ve helped to threaten the integrity of America’s presidential elections.
If anything, some might argue FB is the perfect example of a socially irresponsible investment.
McDonald’s ( MCD) and Nike ( NKE) are two other examples of top-30 holdings in DSI that for one reason or another could very well be excluded from a true ESG fund.
ESG: A (solar-powered?) train leaving the station, with or without you. In the early 2000s, the concept of investing for a difference began to meaningfully change the way investors were allocating their money. The firms, funds and advisors — whether by being more nimble, client-centric, open-minded or attentive than the competition — that adapt to accommodate and welcome the ESG-minded investor with thoughtful products and investment options will do themselves a big favor.
(As if the benefits for the environment and society itself weren’t enough.)
It’s true that ESG investing isn’t an exact science: there are still problems with classification, and measuring the so-called “social alpha” could be improved.
Plus, with the notable exception of perhaps SGIM — the wealth management firm that doesn’t charge AUM fees unless you actually beat the market — most ESG investing options are relatively pricey ETFs, with expense ratios you pay whether you beat the market or not.
[See: 7 Great ETFs for Millennial Investors.]
There are kinks to be worked out, that’s for sure. But all signs point to impact investing being in the early innings of an extended growth cycle.
“Millennials are set to inherit record wealth,” SGIM.com’s Wonboy says. “Consequently, socially responsible investing could potentially have meaningful repercussions on future company valuation.”
“We’re getting a sneak peek of that today with Tesla ( TSLA),” Wonboy says.
More from U.S. News
7 of the Best Stocks to Buy for 2018
10 of the Best Cheap Stocks to Buy Under $10
7 of the Best Dividend Stocks to Buy for 2018
ESG Investing: 4 Important Facts, Stats and Debates for 2018 originally appeared on usnews.com
