Many investors have personal values and priorities they wish to extend to their investment portfolios, be it global warming, income inequality or corporate employment practices. Environmental, Social and Governance Investing (ESG) has skyrocketed in popularity among investors. ESG investing focuses on factors that can also have financial relevance and propel a company to generate positive investment returns. According to an article by Forbes magazine, assets being managed under ESG criteria exceed $20 trillion.
The old adage was that you couldn’t have your investments both ways: you had to choose between a values-oriented portfolio and making money. However, that perception is changing. If companies employ the philosophy of doing good things for the world, they will also do good things for their shareholders. It is estimated that 80% of the world’s largest corporations use ESG standards for setting policies and practices. If you focus on these virtues of a company, you may not see the returns in a short-term earnings report, but instead through longer-term value enhancement. Companies that treat employees well, avoid pollution, listen to customers, give back to their community and possess boards that follow best practices should generate superior long-term returns.
ESG criteria is a set of standards for a company’s operations which investors may use to screen for investment potential. Environmental criteria observe how a company preserves the natural environment. Social criteria rate how a company treats relationships with its employees, suppliers, customers and the towns where it operates. Governance issues relate to management, executive pay, and shareholder rights. There is substantial discretion regarding the defining terms of ESG which can be left to an individual investor’s preference.
How to build an ESG portfolio:
Investors have many options when screening for funds that employ ESG criteria. According to Morningstar, there are about 275 open end funds and exchanged traded funds (ETFs) available in the U.S. which are invested under this strategy. However, since there are no hard and set rules on how to evaluate companies, selection in these funds may vary considerably. Investors will need to read the fund’s policy statement to understand its methodology, and do their own homework to find one that meets their personal goals. As with any mutual fund, focus on low costs and liquidity.
Investors may also build their own ESG focused portfolio by buying individual stocks and bonds of companies that adhere to ESG standards. The annual report on an ESG compliant company will include a section on their ESG performance and practices.
ESG investing and competitive returns:
The general consensus is that while short-term returns shouldn’t be materially higher or lower, ESG investing in the long-term should benefit shareholders. Companies that take into account issues such as sustainability, the environment and social responsibility should do a better job of preserving capital. These actions should limit negative news headlines, lawsuits, government fines, and clean-up costs. All of this reduces risk.
Mistakes to avoid:
Concentration risk – Many of these ESG funds have over 30% allocated to specific sectors such as sustainable energy, water solutions, etc. Investors may not realize what a big bet they are making, and should measure this versus their other portfolio holdings.
Not diversifying among asset classes - Many people view ESG investment options as limited to equity. However, investors need to be diversified between equity and fixed income. Do not avoid bonds because you can’t find a fund that meets your criteria. The result may be detrimental to your overall net worth.
Not having a clear ESG investment objective – You should pick the things that matter to you, be it climate change or renewable energy. To be fully satisfied, make sure your goals align with the funds you choose to invest in.
Effecting positive social change and competitive financial results is an admirable investment goal. However, prudent investing dictates diversification and an astute global asset allocation. ESG investing has the potential to make you feel good about yourself and realize solid long-term returns. Consider it for use as part of your investment profile.
Note: Elaine Phipps, MBA, CFA, is a Portfolio Manager at Point View Wealth Management, Inc., a registered investment advisor at 382 Springfield Ave., Summit.
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