ESG investing has seen a significant boom in recent years; a trend driven by a growing awareness of the importance of sustainable practices and investors’ desire to align their investments with their values. According to data from Morningstar, by the end of 2021, there were 524 ESG funds, up from 392 the year before (and compared to just 104 in 2012). Indeed, 2021 was a historic year for ETFs and ESG mutuals, with a massive $70 billion flowing into ESG funds (up 35% on 2020’s figures). A total of 121 ESG funds were established in 2021 compared to 73 in 2020 and 31 in 2019.

Interestingly, although 72% of Americans claim to be interested in ESG, only 28% of investors say they are familiar with it, suggesting that there is a significant gap in knowledge that needs to be filled. As that gap closes, ESG analysis is becoming an increasingly vital part of a professional investor’s toolkit.

But what exactly is ESG investing?

Simply put, ESG investing is the practice of considering a company’s environmental, social, and governance practices when making investment decisions. This can include evaluating a company’s carbon footprint, labor practices, and diversity and inclusion policies, among other factors.

• E: Environmental factors refer to a company’s impact on the planet, such as its carbon emissions, waste management practices, and use of renewable energy. An ESG investment will prioritize companies that have a positive impact on the environment and avoid those that have a negative impact.
• S: Social factors refer to a company’s impact on people and society, including its employees, customers, consumers, and suppliers. This might relate for example, to treatment of workers, and diversity and inclusion practices. Social factors can also refer to a company’s relationships with the local and wider community. Investors who prioritize ESG may look for companies that prioritize the well-being of their employees and communities.
• G: Governance factors refer to a company’s leadership, business ethics, and internal controls. It can include elements like board independence. Investing in ESG means looking for companies with strong corporate governance practices and transparent leadership, avoiding those that have weak governance or a history of unethical behavior.

Reasons for the ESG investing boom

32% of retail investors are now increasing their ESG investments—a trend not limited to retail investors, as 22% of institutional investors currently use ESG considerations in at least 75% of their portfolio. The boom in ESG investing can be attributed to a range of factors:

·   Social responsibility

Our increasingly interconnected world means that supply chains are more complex, and there is an increased awareness of labor and human rights issues at stake at various points in the process. Many people are starting to recognize the importance of various social and economic issues—accelerated perhaps by the involvement in investing of new demographics, specifically young people, and women, who tend to have a greater interest in ESG issues. And of course, with the threat of devastating climate change becoming more real, environmental factors are becoming increasingly important to everyone.

·   ESG Performance

Beyond being a socially responsible decision, however, ESG investing has also become a sound business decision. In terms of performance, ESG funds have been outpacing the market. Two-thirds of ESG funds beat the market in 2021, and 77% of ESG funds existing 10 years ago have survived compared to 46% of traditional funds, suggesting that not only can ESG investing align with an investor’s values, but it can also provide strong returns.

Companies with a strong track record in ESG have demonstrated resilience and stability, including during the COVID-19 pandemic. At a time of continuing market disruption and uncertainty, it’s clear to see why this kind of strong financial performance has drawn attention from investors.

·   Reducing portfolio risk

One of the reasons for this resilience is that ESG factors pose serious risks to operations and profits in any industry when companies fail to properly consider them. These risks can come in the form of regulatory fines, reputational damage, consumer boycotts and more. Companies that don’t address these risks can suffer financial losses, operational disruptions, and long-term damage to their brand.

Examples of companies that have faced significant ESG-related risks include PG&E, which incurred billions of dollars in liabilities and operational disruptions due to wildfires linked to its power lines; Tyson Foods, which faced consumer boycotts and regulatory fines over its treatment of animals and workers; and Wells Fargo, which suffered fines and reputational damage over its sales practices.

By the same token, companies that actively work to address ESG risks are less likely to be negatively impacted by ESG-related disruptions and are more likely to have more reliable financial results in the long run. In other words, companies that invest in renewable energy, good working conditions, and strong governance practices can reduce the risk of regulatory fines, consumer boycotts, and reputational damage.

Finally, companies with strong ESG credentials are likely to be better positioned to capitalize on new opportunities and trends, such as the increasing demand for sustainable products and services.

ESG analysis and metrics

There is clearly a growing trend for investors to consider non-financial factors, including ESG metrics, when identifying opportunities. However, despite various governments and organizations working to make ESG a regular part of the investment process, it is not yet a standard part of mandatory financial reporting.

One way that investors can assess a company’s ESG performance is through scores and ratings, which are provided by various institutions, such as MSCI ESG Fundamentals, Sustainalytics, and ISS ESG, which measure a company’s vulnerability to ESG risks. Unfortunately, there is no universally accepted ESG rating, largely because most of the ratings organizations rely on companies self-reporting their ESG data. However, these ratings can certainly help investors understand a company’s ESG performance relative to its peers. Reporting tends to follow UN principles for sound governance, or standards set by the Global Reporting Initiative.

ESG: Risks worth taking

A growing body of data shows that ESG stocks are generating superior financial results compared to the whole market. Furthermore, the stock prices are less volatile, and ESG performance can be a great indicator of strong and trustworthy leadership.

However, while ESG investing can provide strong returns, it is not without risk. One risk is that companies may not disclose all the necessary information for investors to make informed decisions, exacerbating the lack of universal ESG standards— as the criteria used to evaluate a company’s ESG performance can vary, it can be difficult for investors to compare companies. There is also very little long-term data on the performance of ESG investments. Finally, legal obligations around ESGs are expected to become more stringent which could rapidly change a company’s standing.

While these risks are all worth considering, the performance of ESG funds suggests that they can continue to provide strong returns. As more investors become familiar with ESG investing, it will be interesting to see how the sector continues to evolve in coming years.

AUTHOR – MATT EITNER