ESG investing has become increasingly popular in recent years as investors have become increasingly aware of the importance of sustainability for the long-term success of companies. That’s why some mutual funds and exchange-traded fund companies have introduced ESG funds to investors. Here’s everything you need to know about ESG funds and how to decide if you should invest in it.
Key learning points
- ESG investing is investing in companies that promote positive environmental, social and governance fundamentals.
- ESG investing is not without controversy, some see it as money making.
- ESG investing is very similar to socially responsible investing (SRI), and people often use the two terms interchangeably.
What are ESG funds?
ESG stands for Environmental, Social and Governance. The acronym identifies companies that engage in business practices that align with the fundamentals of an ESG stock selection.
ESG funds are portfolios of securities and bonds companies that have incorporated environmental, social and governmental factors in their investment process. A company with a strong history and vision in these areas qualifies for inclusion in such an investment portfolio. Conversely, a fund may not consider a company with a poor track record in these areas for inclusion in its portfolio.
Some fund managers deliberately target companies that they believe have room for improvement in addressing ESG risks and opportunities. Greater exposure may prompt a company to further align its operations with ESG standards.
The rationale behind ESG funds is simple. Improving sustainability and quality of life for the people are noble goals. Studies have shown that entities that integrate ESG into their investment decisions outperform those that do not.
For example, a company that decides to stay ahead of government regulations by installing clean air equipment or finding ways to reduce energy consumption can get good press. When investors hear about the company’s responsible risk management, they can extrapolate that the company is generally efficient and adheres to sound principles.
ESG funds are also a way for investors to get involved in environmental and sociological issues that improve life on the planet, while getting a return on their investment.
Why the push for ESG?
ESG as a concept is controversial in many ways. On the one hand, investors who want to help shape a better future for the planet look for companies that demonstrate these principles. On the other hand, many industry names are ideologically against the concept.
ESG has snowballed as a concept and investors have embraced it as a way to make sustainability profitable by encouraging companies to commit to green practices. However, investors should understand that it is still relatively new compared to other investment vehicles.
Arguments for ESG
Many investors, from individuals to large brokers, have enthusiastically turned to ESG investing. a small investor can rest easy knowing that their hard-earned money goes to a company with responsible operations.
Meanwhile, brokers can offer a new portfolio product that combines smart investment principles with stocks from companies committed to making the world a better place. Investing in these companies encourages them to stay on course and use their financial strength to achieve as much good as possible.
Criticism of ESG
The arguments against ESG mostly focus on the lack of definition around the concept and concerns about ‘greenwashing’.
Some critics believe there should be more standards for using ESG as a label and that many operations use the acronym to attract investors who will not look deeper to determine whether the companies are as socially responsible as an ESG rating makes them out to be corpses.
Some conservative critics have argued that ESG funds are not focused on achieving the best possible returns for investors, but instead on efforts by funds to appear more “awake.” As a result, ESG has inadvertently become part of a recent culture war.
Both former Vice President Mike Pence and Florida Governor Ron DeSantis publicly against ESG investing. Some proponents of ESG investing have criticized the Republican backlash as a form of climate denial.
ESG holds promise as a way to combine investing with activism. It addresses many global concerns about our world and encourages companies to create a better future for tomorrow’s children.
However, questions remain about the label’s standards and whether ratings accurately reflect a company’s ethics. Sustainability can mean different things to different people. So while a company may think it is leading the way in its commitment to specific environmental issues, experts may disagree.
Many investors use ESG, socially responsible investing (SRI) and corporate social responsibility (CSR) interchangeably. However, there are some minor differences between them.
ESG investing considers environmental, social and governance factors when deciding where to invest money. SRI is broader and can encompass anything an investor considers important. This could be environmental awareness, faith-based principles, or supporting businesses with good customer service. CSR is what a company does to give back. It includes things like sustainability programs, community involvement and charity.
Usually you see ESG and SRI used together. This is because they contain many of the same principles. Some would argue that sustainable investing is a form of ESG investing. The crucial difference is that SRI can be more flexible in what it considers. ESG has specific environmental, social and governance factors that it focuses on.
How does a company get an ESG rating?
No entity reviews companies and assigns the most ethical ESG rating. Instead, various investment firms, advisory groups, NGOs, and even government agencies may use their own scoring systems for rating companies.
For example, the Institutional Shareholder Service (ISS) is an advisory service that gives companies various scores and ratings, including a carbon risk rating. A group can evaluate a company by communicating directly with its employees about its sustainability efforts or by reviewing publicly available information.
Any of the following factors may play a role in a group’s evaluation of a company:
- Air and water pollution
- Waste management
- Labor standards
- Gender diversity
- Board composition
- Allegations of bribery
In the future, if groups apply a more universal rubric to ESG ratings, the investment practice may become more popular among skeptics. Because there is no uniform SEC rating for ESG, the label can appear inconsistent or arbitrary. Why should we believe that a company is upholding ESG values if it is labeled by one group and not by another?
Examples of ESG funds
Currently, there are over 580 sustainable ESG funds and ETFs available for investment. Here are five of the most popular funds. This is not an investment recommendation on our part. We want to give you the names of certain funds so you can research them further and better understand ESG funds.
Vanguard FTSE Social Index Fund Admiral (VFTAX)
Vanguard’s VFTAX fund includes Apple, Microsoft, Amazon, and Alphabet. It is classified as an aggressive fund and returns tend to be volatile. Despite this, the positions in the fund are solid.
The Vanguard website says the fund excludes stocks “from companies that fail to meet certain labor, human rights, environmental and anti-corruption standards as defined by the UN Global Compact Principles.”
Shelton Green Alpha Fund (NEXTX)
Shelton Green Alpha Fund focuses on identifying companies in the green economy with solid growth potential. It invests in companies that focus on products and services that mitigate environmental and economic systemic risks.
Parnassus Core Equity Fund (PRBLX)
The managers of this fund focus on finding stocks that engage in ESG and exclude stocks that derive the majority of their income from fossil fuels, tobacco, nuclear power, gambling and alcohol. They use ESG screeners to refine their search and identify companies with competitive advantages and ethical practices.
iShares ICLN ETF is an example of how fund managers seek to create and balance ESG funds while adhering to ESG principles. In April 2022, the fund underwent methodological changes to rebalance its holdings. ICLN includes securities including companies that produce solar, wind and other forms of renewable energy.
1919 Social Responsive Balanced Fund (SSIAX)
The 1919 Fund SSIAX fund focuses on high returns from a socially responsible portfolio. It identifies undervalued securities and determines whether the issuing companies operate in a socially responsible manner. SSIAX aims to hold 70% of its assets in US equities and 30% in US investment grade debt.
It comes down to
ESG funds include environmental, social and governance issues in their selection processes. They enable investors to invest in companies with ethical practices. Critics of ESG sometimes argue in good faith. There is no central organization that decides which companies are included in ESG funds, so it is always good to research the selection processes of different funds.
Investing in ESG funds comes down to the individual investor and their beliefs about environmental, social and governmental changes. Investing in these types of funds is not required to have a diversified portfolio. Investors usually invest in these funds to support companies that make a positive impact on the world. But other investors who are not interested in investing in these companies can still invest successfully.