What Is ESG Investing? Why Environmental, Social, and Governance Factors Matter

You’ve heard of sustainable investing, but what is ESG investing and why does it matter? 

Historically, sustainable investing has been a gray area with investors defining ‘sustainable’ in many different ways. ESG investing seeks to clarify this gray area by providing specific factors by which to judge a company’s environmental and ethical impact. 

This means investors consider issues like a company’s carbon emissions or labor practices alongside potential financial gains.

Here’s what else you need to know. 

Table of Contents 

• What Does ESG Stand For?
• ESG vs. SRI: What’s the Difference?
• How Is an ESG Score Calculated?
• Examples of ESG Investments
• Benefits of ESG Investing
• Downsides of ESG Investing
• How to Invest in ESG

What Does ESG Stand For?

ESG stands for environmental, social, and governance. These three factors help investors judge how sustainable and ethical a business is. 

• Environmental impact considers things like carbon emissions or green energy. 
• Social impact considers employee diversity and data security. 
• Governance impact considers executive pay or any lobbying the company is a part of. 

Here are some other factors ESG considers: 

What Does ESG Mean in Investing?

ESG investing is a form of investing where investors consider social responsibility factors such as environmental, social, and governance factors in addition to financial factors. In other words, ESG investing involves investors supporting companies whose ESG values align with their own. 

This may look like forgoing an investment with promising financial gains if the company has low marks related to compensation of overseas employees. Or, it could mean investing in a company that uses renewable energy over one that continues to produce carbon emissions, even if the financial gains aren’t equivalent. 

The idea is that by investing in companies with more sustainable and ethical track records, investors believe they can help create a better, more responsible future.   

ESG vs. SRI: What’s the Difference? 

While ESG investing and socially responsible investing (SRI) both have common goals, there are a few differences. 

ESG investors look specifically at environmental, social, and governance factors when choosing companies or funds to invest in. Socially responsible investors go a step further by including their own personal ethics in decision-making. For example, a socially responsible investor may choose not to invest in a company they find immoral, like an alcohol or tobacco company. 

How Is an ESG Score Calculated?

ESG scores help tell investors how well a company scores in various environmental, social, and governance factors. There is no uniform way ESG scores are calculated. Instead, different third-party agencies use their own unique scoring systems to publish ESG scores for companies.

Because agencies use different scoring systems, it’s important to look into each agency’s rating system if certain issues are important to you.  

For example, Morgan Stanley Capital International (MSCI) rates company ESG scores by 35 key issues determined each year, including carbon emissions, privacy and data security, tax transparency, and more. 

MSCI does not include lobbying in their ESG scores, though. If the way a company lobbies is an important issue to you, the MSCI ESG score may not provide the best estimation.  

Examples of ESG Investments

ESG investments, like any investment, come in an array of options. Whether you prefer investing in funds or individual stocks, there are many ESG options that investors can choose from.

Here are some of the leading ESG investments on the market. 

ESG Mutual Funds and Index Funds 

If you prefer investing in index or mutual funds, there are plenty of options that consider ESG ratings. The latest data from 2021 showed some of the leading sustainable mutual and index funds in the U.S. were: 

Source: Global Sustainable Fund Flows Report

Fund	Net Inflow (4th quarter 2021)
Vanguard FTSE Social Index I	$566 million
Fidelity U.S. Sustainability Index	$552 million
Brown Advisory Sustainable Growth I	$425 million
Invesco Floating Rate ESG A	$316 million

ESG Stocks

If you’d like to seek out a few ESG stocks to add to your investment portfolio, here are some options. These stocks all have high MSCI ESG ratings and saw double-digit annualized growth over the past three years. 

ESG Exchange-Traded Funds (ETFs)

Recent data shows ETF funds provided some of the largest inflows of money for U.S. ESG funds overall. Some of the leading ETF funds worldwide are:  

Source: ETFGI

ETF Fund	Fund Size (by assets in millions of U.S. dollars as of Feb. 2022)
SPDR Bloomberg SASB U.S. Corporate ESG UCITS ETF	$6,750.8
iShares ESG MSCI EM ETF	$6513.1
Vanguard ESG US Stock ETF	$6,115.4
Xtrackers MSCI USA ESG UCITS ETF	$5,044.8
iShares MSCI World SRI UCITS ETF – EUR	$4,970.8

Benefits of ESG Investing

Like any investment, ESG investments come with several pros and cons. 

Let’s start by looking at the benefits. Here are just a few reasons to consider adding ESG investments to your portfolio: 

Support Issues That Are Important to You 

ESG investments allow investors to contribute to companies whose values or practices align with their own. Whether you want to support renewable energy efforts or disincentivize unfair labor practices, ESG investing provides a way to help make a difference. It allows investors to put money where their values will be carried out by the companies they invest in. 

ESG Funds May Outperform Traditional Funds

Most ESG funds (63 percent of them, to be exact) neither outperform nor underperform compared to non-ESG investments. However, it’s more likely to see ESG funds outperform rather than underperform when compared to non-ESG stocks — 30 percent of ESG funds in America outperformed non-ESG stocks while only seven percent of ESG funds underperformed.  

ESG Investing May Lower Risk

According to research by Morgan Stanley Institute for Sustainable Investing, sustainable funds may lower investor risk when compared to non-sustainable funds. In fact, their calculations show sustainable funds consistently show a 20 percent smaller downside deviation than traditional funds. 

Downsides of ESG Investing

While ESG investing comes with several advantages, there are some downsides to consider. Here are some challenges you may face with ESG investing: 

You May Pay Higher Prices

Research from Morningstar shows that ESG investors typically pay a “greenium” compared to investors in conventional funds. ESG investments at the end of 2020 had an average asset-weighted expense ratio of .61 percent compared to conventional funds’ .41 percent ratio. 

You May Have To Pick and Choose Issues

While ESG investing seeks to support environmental, social, and governance factors, investors may find themselves picking and choosing issues. For example, a company with excellent diversity and inclusion practices may produce high amounts of carbon emissions.  

Companies May Advertise Social Responsibility But Not Follow It

ESG ratings are based on public information. They have to be — after all, we can’t know what we don’t know. This means that some companies may advertise social responsibility to boost their ESG ratings while not actually practicing it. 

How To Invest in ESG

If you decide you want to begin investing in ESG options, there are a couple different strategies you can use. Here are a few ways to start building your ESG portfolio with more sustainable and ethical companies. 

Research Options Yourself

For those who prefer a hands-on approach, you can research and find investment options yourself. This includes investing in stocks, funds, or other securities. To begin, you’ll need to open an online brokerage account if you don’t already have one. 

Once you have your brokerage account set up, you can research ESG investment options using tools like: 

• As You Sow, a site that breaks investment funds down by values such as deforestation.   
• Morningstar’s ESG screener, a tool that allows you to search investments by your sustainability preferences. Try using “ESG” as a search keyword. 
• MSCI’s ESG Ratings and Climate Search Tool, a site that allows you to check individual companies’ standing on sustainability and ethical issues.   

Use Robo-Advisors 

Robo-advisor accounts offer a more hands-off approach. With this strategy, investors open an account, pay a small management fee, and robo-advisors automatically find and invest in options according to your preferences. 

Be sure to find a robo-advisor account that offers ESG options that align with your values. Each account will define ESG or socially responsible options differently, so double-check their methodologies if certain issues are important to you. 

Some robo-advisor accounts that offer ESG investing options include: 

• Betterment
• Earthfolio
• Wealthsimple
• Sustainfolio

Consult a Financial Advisor

If you want an ESG investment strategy that’s both a little hands-on and a little hands-off, consider consulting a financial advisor. This allows you to have control over picking your investments while also providing you with expert knowledge. 

To find a financial advisor, ask your network for recommendations or try an online search. Before cementing the relationship, ask for an introductory call to make sure it’s a fit. This is where you can ask candidates important questions, like what ESG investment options they’ve recommended to past clients.   

Ready to start investing in ESG? Open an investment account with one of our partners or start tracking the accounts you already have. By investing in ESG, you can help build a more sustainable and ethical world for our future.

Sourcing

• MSCI rates ESG scores by 35 key issues. MSCI ESG Ratings Methodology (June 2022)
• Leading U.S. sustainable funds as of 4th quarter 2021. Global Sustainable Fund Flows Report, page 18 (January 2022)
• Top ESG stocks by MSCI rating and annualized growth. 10 Best Stocks for ESG Investing (Sept. 2022)
• Leading worldwide ETFs with ESG focus by net new assets as of February 2022. ETFGI reports ETFs focused on ESG strategies listed globally gathered net inflows of US$7.55 billion during February 2022 (March 2022)
• ESG funds may outperform non-ESG funds. ESG Survey – What corporates and investors think (November 2021)
• ESG funds may lower investor risk. Sustainable Reality: Analyzing Risk and Returns of Sustainable Funds (2019)
• ESG investors may pay a “greenium.” Morningstar 2020 U.S. Fund Fee Study (August 2021)