Understanding ESG Investing: The Good, the Bad, and the Complicated

In 1970, economist Milton Friedman wrote, “There is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits.”

Friedman’s idea that maximizing shareholder value should be the top priority became the prevailing belief in the financial world. 

However, in 2019, 181 CEOs signed a Business Roundtable statement advocating for a broader purpose. The CEOs believed companies exist for the benefit of customers, employees, and whole communities, not just shareholders.

According to President and CEO of Progressive Corporation Tricia Griffith, “CEOs work to generate profits and return value to shareholders, but the best-run companies do more. They put the customer first and invest in their employees and communities. In the end, it’s the most promising way to build long-term value.”

The Business Roundtable statement solidified a trend that had been on the rise for years. ESG investing, a socially conscious investment strategy, was rapidly taking over the investment world. In 2020, 78% of investors incorporated ESG into their investment processes. But in recent years, some investors are raising concerns that this trend isn’t worth the hype. 

So, is ESG investing the best way to maximize your profits, support your values, and promote positive change? Or is it a well-intentioned investment strategy gone wrong? In this article, learn how ESG investing can benefit you and what to consider before starting. 

What Is ESG Investing?

ESG investing, or environmental, social, and governance investing, means looking at how a company treats the environment, impacts society, and runs its business while making investment decisions. ESG investors aim to reduce their financial risk by investing in companies with little exposure to ESG-related risk factors that could ultimately impact returns. These factors could include issues such as corruption in the company, poor working conditions, and environmentally harmful practices. 

The goal of ESG investing is to achieve positive outcomes both for investors and society at large by investing in companies that are committed to making a positive impact. 

How Does ESG Investing Work?

ESG fund managers and investors evaluate a company’s ESG practices when building their portfolios. Here’s a list of common ESG factors: 

After investors have evaluated several ESG factors, they choose an investment strategy. The following are the most common ESG investment strategies:

ESG Investment Strategies

• Exclusionary screening: This approach involves excluding companies or sectors that engage in activities that do not meet specific ESG criteria.
• Positive screening: While exclusionary screening excludes certain companies, positive screening involves actively seeking out companies or sectors that show strong ESG performance. 
• Thematic investing: This approach involves investing in companies that are aligned with specific ESG themes or issues, such as climate change, social justice, or gender equality.
• Impact investing: This approach involves investing in companies or projects that aim to generate positive social or environmental impact alongside financial returns.
• Active engagement: This approach involves actively engaging with companies to encourage improved ESG performance or using shareholder advocacy to promote positive change

How Do ESG Ratings Work? 

Fund managers and individual investors often rely on ESG ratings to determine whether a company follows good ESG practices. These ratings measure the risk to the investor that a company’s value could drop due to poor ESG practices. Several agencies analyze companies and provide ratings to help investors make informed decisions. MSCI ESG, Sustainalytics, and ISS ESG are some of the most commonly used rating agencies. 

An ESG rating tells an investor how much exposure to ESG-related risk a particular company has. For example, Sustain Analytics gives Microsoft Corp. a 15.3 rating, which it considers “low risk.” A company with a rating between 20–30 would be considered medium risk, while a company rated 30–40 would be considered high risk. The company Alectra Inc. received a 45.5 rating, meaning it is at severe risk of being harmed by its poor ESG practices. 

Benefits of ESG Investing

1. Potential for Strong Returns

Several studies show that ESG funds perform well compared to the market. In May 2022, the European Securities and Markets Authority (ESMA) published a study showing ESG investments performed better than non-ESG investments between 2019 and 2021. The study found that funds focused on the societal and corporate governance pillars of ESG were especially likely to outperform other funds. 

Some analysts believe ESG funds can be more resilient during down markets. In 2022, when the S&P 500 fell by 19.4%, Morningstar reported its broad Sustainability Index fell only 18.9%. 

While ESG investing has the potential for strong returns, it’s important to remember that potential is the keyword. It’s critical to choose the right ESG investments and consider the financial data of the companies you’re invested in. For example, in 2022, growth-based funds struggled, so Morningstar’s growth-based ESG funds underperformed its value-based funds. 

2. Alignment With Personal Values

While achieving strong returns is an investor’s first goal, it’s nice to know that your investments support companies that share your values and avoid companies that negatively impact the world. For many investors, ESG is a win-win, allowing them to earn money without compromising their values. 

3. Reduced Investment Risk

ESG investors typically believe that good ESG practices protect against ESG-related risks. Capital.com’s Isbrucker explains, “A heavy emitter isn’t just bad for the environment. It’s also prone to penalizing regulations or carbon taxes, which could affect the bottom line.”

Corporate corruption, poor employee working conditions, discriminatory practices, and efficient use of resources are all ESG-related risk factors that could hurt a company’s bottom line. ESG ratings inform investors of whether or not a company has high exposure to these risks. 

Criticisms of ESG Investing

In recent years, some investors and analysts have raised concerns about ESG initiatives and investing. In fact, Florida Governor Ron DeSantis recently passed legislation intended to keep ESG considerations out of state investments. The following three reasons have been the primary drivers of the doubt surrounding this investment strategy: 

1. Real-World Impact Is Unclear

In 2021, Blackrock’s Tariq Fancy left his position after becoming disillusioned with the world of ESG, saying, “I think over time, I started to realize that the majority of the work we were doing had no real-world impact.”

Fancy further explained his views in an online essay: “Green bonds, where companies raise debt for environmentally friendly uses, is one of the largest and fastest-growing categories in sustainable investing, with a market size that has now passed $1 trillion. In practice, it’s not totally clear if they create much positive environmental impact that would not have occurred otherwise.”

2. Experts Disagree on the Financial Benefits

In 2022, Harvard Business Review reported, “ESG funds typically charge fees 40 percent higher than traditional funds, making them a timely answer to asset management margin compression.”

Fancy believes higher returns rarely offset the cost of high fees. He says, “The promise of ESG at its core was meant to be that it’s good for investment returns, it’s good for the planet—so it’s a win-win—and a third win: that it’s good for asset managers because they get more in fees. Unfortunately, the first few years of ESG we’ve seen, it’s really only the third one that’s happening.” 

3. Difficulty Providing Objective Ratings

While ESG ratings are intended to inform investors whether companies are avoiding ESG-related risks and participating in socially responsible business practices, it can be challenging to provide an objective rating. 

While ESG rating agencies try to keep investors informed, these agencies often disagree. A 2019 study found significant variations between the ESG ratings from six different ESG rating agencies. 

How to Become an ESG Investor

If you’ve weighed the pros and cons and ESG feels like the right investment strategy for you, here’s how to get started:

1. Identify your values: Determine what issues are important to you when it comes to investing. Do you share concerns with environmental investors? Or are you more focused on social issues like diversity and inclusion? 
2. Evaluate ESG funds: Once you have a clear idea of what you’re looking for in an ESG investment, research different ESG funds that align with your values. Look at their ESG rating, performance, expense ratio, and any other factors that are important to you.
3. Open an investment account: If you don’t already have one, open an investment account that allows you to invest in ESG funds. There are a variety of investment platforms that offer ESG investment options, including robo-advisors, traditional brokerage firms, and socially responsible investment firms.
4. Choose your ESG funds: Select the ESG funds that align with your values and investment goals. Consider diversifying your portfolio by investing in funds that focus on different ESG factors, such as environmental or social issues.
5. Track your investments: Keep an eye on the performance of your ESG funds, and make adjustments to your portfolio as needed. Also, be sure to review your investments periodically to ensure they continue to align with your values and investment goals.

Dig Deeper to Be an Informed ESG Investor

Because the pros and cons of ESG investing are far from settled, it’s especially important to stay informed about the topic. If you’re considering ESG investing, keep these three tips in mind: 

• Be aware of evolving ESG laws and regulations: ESG investing is a popular topic among legislators right now. Many leaders at the federal and state levels are actively discussing laws to restrict or promote ESG investing. As these debates continue, be aware of the arguments both for and against this investment strategy. When it’s time to vote, make sure you know whether your preferred candidates share your opinion on the issue.
• Look past surface-level claims: While many companies truly work hard to combat climate change, promote human rights, and adopt ethical business practices, others may use ESG terminology simply for marketing purposes. Any time you invest in a company or an ESG fund, do your research to ensure you are supporting the causes you care about. 
• Evaluate a stock’s financial performance with tried-and-true methods: Whether you’re ESG investing or using another investment strategy, always remember to make decisions based on important financial metrics and historical financial performance. Learn about evaluating stocks by reading investing books. Also, listen to the advice of investors with long-term successful track records like Warren Buffett, Ray Dalio, or George Soros. 

To learn more about ESG and socially responsible investing (SRI), check out “What Is Socially Responsible Investing and What Is Its Impact?” 

To read more about the debate surrounding ESG companies, learn about Elon Musk’s plans for Tesla Giga Texas.