You may not get to have your cake and eat it, too, but you can have your returns and invest responsibly thanks to ESG investing.
Many investors view ESG as just another means of socially responsible investing, but ESG investing can – and many experts say should – serve another role in your portfolio: that of risk reduction .
"ESG is a framework through with you can compare like firms or investments to understand their risk relative to environmental, social or governance factors," says Andrew B. Wetzel, who spearheads ESG investing as a senior vice president and portfolio manager at F.L.Putnam Investment Management Company.
It's meant to be a tool for evaluating how these factors may impact a company's performance. "If applied in the right way it can be very helpful in terms of managing risk," Wetzel says.
How ESG reduces your risk. ESG investing seeks to quantify risks that can't be measured by traditional financial metrics. You can assess a firm's financial risk through its financial statements, but where in the annual report is the risk to workers of unsafe working environments quantified? Or the risk that government regulation will force a company to rectify its poor but profitable environmental practices?
It's these seemingly unquantifiable risks that ESG ratings measure.
Environmental criteria considers a company's environmental impact through its energy and natural resource use, pollution and treatment of animals. Social criteria includes how a company treats its employees and its relationships with other businesses. And governance looks for potential conflicts of interest among board members and at a firm's accounting and investment practices.
"ESG reports highlight all these risks, [plus] controversies such as lawsuits, in detail and provide rankings among peers in the same industry," says Asli Ascioglu, a professor of finance at Bryant University. "Academic studies have shown that companies with better ESG scores have lower share price volatility and fare better in times of crisis."
Higher-scoring ESG companies "tend to have the characteristics of higher quality businesses," such as higher profit margins and more stable returns, Wetzel says.
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In short: "Companies with good ESG practices are just managed better," Ascioglu says. And adding them to your portfolio can increase your risk-adjusted returns .
How to implement ESG investing. There are two primary ways to apply ESG to your portfolio: through momentum investing or a best-in-class approach. With ESG momentum investing, you underweight any companies that have experienced recent ESG rating downgrades.
Negative ESG momentum can be a bad omen for companies. Just look at Equifax (ticker: EFX ): The year before its data breach and resulting stock nosedive, Equifax's ESG rating was downgraded for a lack of data security measures.
But even before this, Equifax's rating was on the lower side for its peer group. An investor using the best-in-class approach probably wouldn't have held the company to begin with.
With best-in-class investing, you hold only companies ranked in the the top 80 to 90 percent of their peer group. Excluding the bottom 10 percent of ESG companies is crucial because these are the companies that bring "excess risk to the portfolio," Ascioglu says.
"Investors should look at their portfolio and remove any exposure to low ESG companies, especially with recent downgrades in their ESG ratings," she says.
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Compare companies in the same industry or sector. If you try to invest in only the highest-scoring ESG companies across the entire market, "you'll end up with a bunch of tech stocks," says Martin Kremenstein, head of retirement products and ETFs at Nuveen. When comparing ESG companies, take an industry-specific approach .
Each ESG factor will affect industries differently. "For example, if you're evaluating a company in the transportation business, the levels of greenhouse gas emissions is important, but in the health care industry, product quality and safety are the main drivers for their success," Ascioglu says.
Materiality, or the likelihood that information or an event will impact investors, is a key component of ESG rankings. The Sustainability Accounting Standards Board has an online tool that charts the materiality of various sustainability issues to individual industries and sectors. MSCI and Sustainalytics, the largest providers of ESG ratings, factor materiality into their grading. Subscribers can view their ESG scores online or through third parties. Some financial services providers like Fidelity also provide ESG information to clients.
Use ETFs for broader exposure. Ascioglu recommends using exchange-traded funds for a simpler and more diversified approach to ESG investing. Many fund providers, including BlackRock, State Street and Fidelity, have ESG ETFs.
For instance, the iShares MSCI USA ESG Select ETF ( SUSA ) holds 100 of the highest-ranking ESG companies according to MSCI's ratings, weighted by their scores. The iShares MSCI KLD 400 Social ETF ( DSI ) takes a positive and negative screening approach by investing only in positive ESG companies while excluding firms significantly involved in weapons manufacturing, vice products, nuclear energy or genetic modification. The State Street Global Advisors: SPDR S&P 500 Fossil Fuel Reserves Free ETF ( SPYX ) eliminates companies that own fossil fuel reserves from the S&P 500.
Morningstar and ETF.com provide ESG and sustainability ratings for funds. But make sure to look behind the ratings to see if the fund manager has a true commitment to ESG.
There's a difference between "what's being said and what's being done," says Patrick Drum, portfolio manager of the Saturna Sustainable Bond Fund at Saturna Capital. It's one thing for a fund to label itself as sustainable, but what actions is it actually taking toward ESG governance?
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"How do they incorporate those [ESG] behaviors?" Drum asks. And "how do they measure the characteristics of their portfolio from an ESG perspective?"