ESG investing, which mitigates the risks associated with environmental, social, and corporate governance issues, is becoming the new holy grail of investing. Finally there’s a way to do right by the world and your portfolio, too. By investing in companies or funds that have been screened for ESG criteria, you can invest responsibly while also increasing your risk-adjusted returns.
If you’re hearing a “but” coming, you know reality is seldom as simple as someone handing you the holy grail on a silver platter. Successful ESG integration requires more than just buying the first best-in-class ESG investment you find.
“ESG investing needs to be treated like any other investment decision,” says John Cochrane, a senior associate at the The U.S. Impact Investing Alliance in New York. Forgetting this leads to some of the biggest mistakes investors make with sustainable investing.
ESG mistake No. 1: Being too concentrated. “The most common mistake for investors when it comes to ESG or responsible investing is making concentrated bets,” says Brendan Erne, director of portfolio implementation at Personal Capital in San Francisco. And often they don’t even realize they’re making them.
It’s the quintessential fund investor faux-pas: “Since they’re investing in a fund, they assume they’re getting broad diversification, but some of the most popular [ESG funds] have more than 30 percent allocated to single sectors,” Erne says. “Those are big and potentially dangerous bets.”
To avoid unintentional over-concentration, he says to “pay attention to the underlying makeup of the fund, since there are options that diversify better than others.”
[See: These 7 Funds Make You Feel Good About Investing.]
ESG mistake No. 2: Not diversifying. Yes, diversification is still important. And thanks to the growth in ESG investment options, it’s becoming easier to do.
Even when you narrow your investment options to only best-in-class companies for ESG, it still leaves a big enough universe to diversify and avoid concentration risk, Cochrane says.
That isn’t to say you should limit yourself to only best-in-class companies, however. ESG investors still need to “incorporate all major liquid asset classes” in their portfolios, Erne says, even those that may not be “ESG-optimized.”
“For example, don’t exclude bonds from your portfolio simply because you can’t find an ESG bond fund that meets your criteria,” he says.
And there are companies within industries you might not view as ESG friendly which are doing great work around ESG factors as companies realize the importance of those factors, Cochrane says.
Jennifer Sireklove, the Seattle-based director of responsible investing at Parametric Portfolio Associates, points out that if changing the world is your objective, investing in poorly-rated ESG companies can actually be a more effective means of accomplishing that. If you want companies to improve their environmental, social, or governance practices, “you should also own companies that are falling short of expectations — not just those exceeding them — and use voting and engagement to try to influence them to improve,” she says.
[See: 13 Things to Know About CEO Pay Ratios.]
ESG mistake No. 3: Not having a clear ESG investment objective. Investors, portfolio managers, and company executives can all approach ESG from different angles. For instance, as an investor, you may use ESG investing because you’re worried about climate change and want to eliminate carbon from your portfolio. Meanwhile, a portfolio manager may view renewable energy as an opportunity to outperform the market, which may or may not mean eliminating carbon. You want to make sure a portfolio manager or company is approaching ESG investing the same way you are.
“ESG investing comes in so many flavors, it’s often hard to discern exactly what a strategy is trying to accomplish and how it’s able to do this,” Sireklove says. To help you translate your investment objective into an investment strategy, she breaks it down like this:
— If your objective is ethical consistency, look for a strategy that screens stocks with criteria matching your principles.
— If you want to outperform or reduce volatility, ignore the ESG label and evaluate the strategy as you would any other investment.
— If you’re trying to change the world, find a strategy with strong voting and engagement activity.
But what if you want to do all of the above? This is another area where ESG investors often go wrong.
ESG mistake No. 4: Trying to do it all. No one likes to choose between the desserts on the menu. And while it would be great to align your investments with your morals while still outperforming and changing the world, trying to find an investment to do all of this is not only headache-inducing but also risky.
“Applying too many filters can significantly reduce the available investment universe and lead to material performance deviations,” Erne says. “Be careful to not completely tie [your] hands.”
[See: 8 Ways to Build a Low-Cost Portfolio for Social Change.]
Instead of trying to find a strategy to do it all, Sireklove says to make one objective your priority. “Find a manager who you believe can execute on that one thing well,” she says. “If you get some of the other objectives met too, that’s icing on the cake.”
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4 Mistakes Investors Make with ESG Investing originally appeared on usnews.com
