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What is ESG? Understanding ESG Investing and its Profitability

Anyone evaluating their investment options in the last few years will have come across the acronym ESG. In recent years, interest in environmental, social and governance (“ESG”) issues has skyrocketed, with more and more people wanting to make it a part of their broader investment portfolio. 

As ESG has grown into a prominent field, it has opened up a range of business and investment opportunities. A more socially conscious population means that, in short, businesses with positive social outcomes become more attractive propositions. This has, in turn, filtered its way into board rooms across the world – ESG is generally considered to be a rapidly growing trend and one that is becoming impossible for investors and wealth managers to ignore. 

What does ESG investing mean?

‘ESG’ investing is an umbrella term for investing that aims to make returns while also having a positive social impact. Essentially, this means investing in companies that perform well against the ESG criteria. 

Put simply, ESG is a way of evaluating a company’s environmental and social impact. It represents a set of positive social outcomes against which a business or an investment can be measured. These can include anything from the company’s energy use to its treatment of animals. It is, essentially, another layer of performance information, giving investors more context than traditional financial data alone. 

How does ESG work?

The precursor to ESG investing, ‘ethical investing’, was based on excluding or ‘screening’ companies or industries based on a set of criteria. So, for example, if a company had a significant stake in tobacco or arms, it would be excluded from the ethical investment horizon. As a result, these funds generally came with higher risk and lower returns, meaning they struggled to gain serious traction. 

ESG investing is a more wholesale approach. It involves seeking out and investing in companies because of their positive characteristics rather than a process based on exclusion. What you end up with, then, is an investment approach that has positive social outcomes baked in and an altogether less restrictive approach. 

At its core, ESG investing is about channelling investment into companies that not only have positive financial prospects but also practice ethical corporate behaviour. It is the process of determining worthwhile investments based on the social and environmental impact of the company in question, as well as the company’s exposure to ESG-related risks.

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The growth of ESG in investing

In the world of investments, ESG has established itself as a concept and grown rapidly over the course of a few years. Both in terms of the capital it represents and the number of investment vehicles out there, ESG has grown dramatically to cater to the changing demands of investors. 

Between 2018 and 2019, for example, annual ESG fund flows in Europe increased from £45 billion to some £108 billion. Similarly, the number of funds available grew by 360 in 2019, to a total of 2,405, according to data from Morningstar. 2019 was, in many ways, the year ESG hit the mainstream, with some questioning whether the momentum could be maintained going forward. 

The momentum was, it seems, carried into 2020. The spread and impact of Covid-19 have brought issues of sustainability into sharper focus – specifically, it has highlighted the fact that global environmental and social problems cannot be solved by isolated government policy alone. The financial sector has a key role to play in ensuring that we achieve positive change. 

Even before Covid-19, consumers and investors were becoming more focused on environmental and social issues. A business with sustainability and ethics baked in can appeal to these considerations, putting them at the top of the agenda for private company executives. It seems that, after decades of investor pressure on issues like sustainability, the corporate world is transforming. 

The bottom line is that ESG is something investors will increasingly consider making a part of their portfolio. From both an ethical and a growth standpoint, the development of socially and environmentally responsible investing is encouraging, making it increasingly difficult to ignore. We’ll discuss the financial viability of it next, but in terms of growth and popularity, ESG is very much in vogue. 

How profitable is ESG investing?

Of course, when people invest, they do it to protect and grow their wealth. ESG, as a proposition, will only succeed if the returns available to investors are (at least) comparable to those associated with more traditional investments. 

Historically, ESG investing has come with a perceived performance trade-off that has put a lot of investors off. On a fundamental level, any limitations put on the opportunities available to investors could have a negative impact. This is becoming less of an issue on an almost weekly basis, though, with new funds launching in line with rapidly increasing demand. In fact, this perceived trade-off is something of a fallacy in 2021. 

Even a cursory look at the numbers highlights ESG’s potential to outperform. One research paper on ESG investing found that, in the first four months of 2020, “more than 70% of funds focused on ESG investments outperformed their counterparts.” Similarly, “nearly 60% of ESG funds outperformed the wider market over the past decade.” ESG is certainly not a foolproof ‘win-win’ of ‘doing well by doing good’, but the vital signs of what is a nascent market are encouraging. 

ESG investing, however, isn’t something investors should rush to without performing adequate research. According to a report by Boring Money, 52% of people don’t know enough about ESG to invest in it confidently. The same report found that 66% want their investments to have a positive impact – the challenge now is for technical understanding to catch up with demand.  

What are the key concerns with ESG investing?

There are some issues with ESG investing that need to be overcome. One of the biggest of these challenges can be found in the definition of ESG itself – there is a lack of clarity around what we mean when we use terms like ‘sustainable’, ‘green’, ‘ethical’ or ‘socially responsible’. 

This ambiguity can make it difficult for investors to know exactly what they are investing in. The popularity of ESG investing means that there is an incentive for a fund to include these terms as buzzwords that fall apart upon closer inspection. This has a knock-on effect on people’s understanding of ESG investing more broadly – Boring Money’s report found that only 35% of people feel confident defining ‘sustainable’, while only 18% felt confident with ‘ESG’. 

Progress is being made in this area already, though, with drives for standardisation like the one led by the Investment Association. In November 2019, it launched a responsible investment framework that aimed to standardise terms like ‘ESG integration’, ‘sustainability focus’ and ‘impact investing’. Properly defining and quantifying terms like these is a major step in improving the understanding of (and confidence in) ESG investing. 

So, steps are being taken in the right direction, and the situation will improve with better education and transparency. But for now, demand is growing, boosted in part by the Covid-19 crisis, and ESG investing is an area we will be keeping a close eye on over the short, medium and long term. 

Why you should choose ESG investing

Here are some of the benefits of investing in ESG investment funds or portfolios.

  • Positive financial performance: A study conducted in 2015 that combined over 2,000 individual studies found that ESG factors were consistently associated with better investment returns. From 1970 to 2015, 90% of companies that incorporate ESG criteria into their business practices have had an equal or better financial performance than those that didn’t.
  • Outperformance and reduced volatility: A study conducted in 2016 found that companies with ESG integration generated higher returns and showed lower volatility than their peers in the same industry. Stocks with high ESG ratings and high ESG portfolios outperformed peers in 8 out of 12 industries, especially in the energy and food & beverage industries. ESG portfolios and stocks with high ESG ratings came with lower volatility, while low ESG stocks showed additional risk. The study analysed returns from 157 companies listed in the DOW and 809 random equities from 2014 to 2016.
  • Positive impact investing: Investing in companies that share our political, religious or personal values while generating a positive social impact and measurable ESG impact is good for the society and the environment. ESG investors encourage companies to move towards more sustainable business practices.

How can you find ESG Investments?

There are several ways to find ESG investments. They include.

  • Evaluate corporate reports: One way to find ESG stocks is to investigate the companies that meet your criteria. Companies publish sustainability reports that list their ESG goals and the initiatives that have been achieved. Go through the reports to find the ESG stocks to invest in.
  • Evaluate ESG funds: ESG funds are an alternative option for those who want an easy way to invest in ESG stocks without researching individual stocks themselves. Only companies that meet the fund’s inclusion criteria are included in the fund, so you’re sure that whatever is in the portfolio.
  • Robo-advisors: If you don’t want to be bothered by investing decisions and investment management, you can let a robo-adviser handle your investments. To start, you’ll want to find an online robo-advisor that offers ESG investing options. Then you’ll tell the robo-adviser that you want to invest in these funds.

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