When getting started in the stock market, there are a number of different factors to consider. Do the investments you’re selecting provide steady, long-term growth? Do they generate income in the form of dividends? Are they part of sectors that are likely to grow rapidly in the years ahead? But there’s another set of factors that is becoming increasingly important, especially to younger investors: environmental, social, and governance—otherwise known as ESG investing.
Simply put, ESG investing is a way for investors to apply non-financial measures when looking at the risks and growth opportunities of any given company. Environmental issues tie back to how a company addresses things like carbon emissions, air and water pollution, and waste management, for instance. The consideration of people and relationships falls under the “S” or social component, including gender and diversity issues, human rights, and labor standards, among many others. And finally, governance refers to the standards for how a company is run: board composition, bribery and corruption standards, executive compensation, and lobbying.
Various organizations rate or rank companies on these metrics; companies with high ESG scores tend to be in growth industries, have better governance, and a more diverse employee base. Conversely, companies with lower ESG scores are usually found in declining industries, have greater employee turnover, and therefore have more risk factors associated with them.
While they’re gaining in importance, ESG metrics are not typically part of mandatory financial reporting. But since these issues are becoming increasingly important to investors as they decide where to put their money, more and more companies are reporting on their efforts in their annual report or other documents.
It’s not difficult to see why.
There’s about $30 trillion of wealth now being transferred from baby boomers to their children and grandchildren, says Dave Nadig, chief investment officer and director of research for ETF Trends. “These younger investors are shown to care deeply about ESG issues, so asset managers and advisors are scrambling to adjust to this new reality,” he says. And according to data from Bank of America, the size of the ESG fund universe over the next two decades is projected to reach $20 trillion.
The growth of these funds is already robust. During the second quarter of this year, the money that flowed into ESG-focused funds reached $10.4 billion, bringing the total to $20.9 billion for the first half of this year, according to Morningstar. That’s just shy of the total amount that flowed into ESG funds for all of 2019.
For investors looking to take ESG into consideration when investing, there are still a few things to keep in mind. For starters, ESG isn’t a guarantee of superior financial performance. “We don’t think that anybody should be looking at ESG ratings, and regardless of the price of the stock, invest in that stock just because the company has a good ESG rating,” says Simon MacMahon, head of ESG research for Sustainalytics, an ESG and corporate governance research and ratings firm. “ESG information is best understood as complementary data that, when combined with financial information, can help investors understand the risk and opportunities associated with that investment.”
The other thing to keep in mind is that ESG funds can screen differently. There are mutual funds and ETF (exchange-traded funds) that simply exclude companies in industries such as tobacco, firearms, and gambling, for instance. Then there are funds that are specifically designed to screen for companies that are having a positive impact on the world by either decreasing their carbon footprint, for example, or by having concrete strategies for hiring more women and minorities to their executive ranks. The iShares MSCI Global Impact ETF (SDG), for instance, has a portfolio made up of companies around the world whose operations further the United Nations’ Sustainable Development Goals, including clean energy, eliminating poverty and hunger, and stopping global warming.
It’s up to each investor to understand what’s most important to him or her, and then use that as a guide to find the companies and funds that align with that. Two funds can claim to be ESG funds, yet focus on entirely different issues.
An LGBT fund and a Catholic Values fund are both considered ESG funds with an emphasis on the social component, yet their portfolios are vastly different, says Nadig of ETF Trends. Working with a financial advisor that is ESG-aware is a good way to sort through different ESG funds and ETFs, says MacMahon. “They can help a beginner investor understand the different reports and research so that the ESG investment really does line up with what’s most important to that particular investor,” he says.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.