If you have heard about ESG investment, you know that it refers to companies that focus on environmental, social, and governance issues.
There are a variety of motivations behind the ESG movement. While some investors want their money to go towards companies and projects that will change the world, others simply want to minimize the harm that their investments have on communities and ecosystems.
Then, there is a third group who are looking to use ESG principles to protect their own portfolio from potentially negative impacts. But no matter the motivation, all ESG investors want to make a return on their money.
It might sound straightforward, but it is much harder in practice than in principle.
For an example, how do you decide whether a company deserves to be classified as ESG-friendly?
Take Tesla. The company makes electric cars which are better for the environment than traditional ones.
So you would think this investment would have a positive effect on the environment – but not so fast.
There are questions around the environmental impact of mining nickel, which Tesla uses in its batteries and is the electricity used to charge a car coming from renewable or non-renewable sources.
So, what do you do if you want to invest in environmental progress?
These days most people don’t have to make that decision. A rise in passive investing means that most investors choose an index-tracking fund, like an ETF or a mutual fund, which puts their money into a basket of company stocks that track an index.
To create an ESG-focused index simply means that the companies in that basket have met certain criteria that make them ESG-friendly.
The sheer number of indices that provide an ESG focus have exploded from 2019 to 2020, increasing by 40%, according to the Index Industry Association survey.
The amount of money going into ESG assets has also exploded. In the United States in 2016 there was $8.1 trillion in professionally-managed ESG assets, according to the Forum for Sustainable and Responsible Investment.
By 2020, that number grew to $17.1 trillion, which is more than a 100% increase in just four years.
As for figuring out which companies to put in those indices we mentioned, many index providers rely on various metrics that score companies based on their ESG impact.
Example of metrics are things like exposure to carbon-intensive operations, energy efficiency, human rights concerns, and many more.
However, there can be discrepancies between the ratings agencies, even when they are scoring the exact same company. Often, index providers will have a committee that helps make decisions on which companies to include and which to exclude. This is important because the company stocks they include will benefit from more investor cash.
But the subjectivity of classification has led to controversy over whether some funds are truly investing in companies that fulfil the vision of ESG or whether some index providers are merely using it as a marketing term and putting the “ESG” label on funds that don’t really merit it.
This is why it is so important for investors to carefully read the methodology and perspectives behind an ESG index before they invest to ensure that they are getting something that truly reflects their goals.
A question you may be asking right now is whether the returns of those ESG funds are better or worse than traditional investments.
Some ESG funds may do better than the benchmarks, others may do worse. But the beauty of ESG is that, in general, investors don’t need to worry about sacrificing performance for doing good.
And perhaps, that is why we see so much money jumping on the ESG bandwagon.