What is ESG Investing? - 3 Step Guide (2021)
Sustainability.
The word carries a lot of meanings, especially in the investment world…
If you've ever asked yourself - "how do I become a sustainable investor?"
Carry on reading and you will find all the answers!!
In this article we will cover...
What does ESG mean in investing?
ESG stands for Environments, social and governance, ESG investing basically entails looking at those 3 factors when making investing decisions.
ESG investing allows companies and really any investors to screen their investment decisions to check their sustainability but more importantly some more intangible factors like their morality…
Environmental criteria consider how a company performs as a steward of nature.
Social criteria examine how it manages relationships with employees, suppliers, customers, and the communities where it operates.
Governance deals with a company’s leadership, executive pay, audits, internal controls, and shareholder rights.
With society becoming more and more aware of global issues such as climate change the rise of ESG investing has many reasons.
The more people want to do good with their money (and make good returns) the better for the planet as investing in businesses and economies that are improving the state of the world, we live in isn’t just moral, but it will bring you lots of value as an investor.
3 Step Guide: How does ESG investing work?
ESG investing is split into three sections:
Environmental
Social
Governance
These sections represent different factors that ESG investors consider when looking at opportunities in the market.
The first factor is Environmental.
This could include how sustainable their factory process is if they are making physical products and what they are doing to actively not only make their operations greener but also how are they helping the rest of their industry do the same.
A company that is trying to make a positive different to the environment would therefore look like a better, or more deserving, investment than one that is not.
Some key aspects of environmentally conscious companies to look out for are…
Climate change policies.
Greenhouse gas emissions goals and transparency about how the company is meeting those goals.
Carbon footprint (pollution and emissions).
Water-related issues and goals, such as usage, conservation, overfishing, and waste disposal.
Usage of renewable energy, including wind and solar.
Recycling and safe disposal practices.
Green products, technologies, and infrastructure.
Environmental benefits for employees, such as bicycle commuting rewards programs and environmentally based incentives.
Relationship and history, if any, with the U.S. Environmental Protection Agency (EPA) and other environmental regulatory bodies.
For more objective analysis you can always look to various reports on sustainability like the Global Reporting Initiative (GRI) and the United Nations Principles for Responsible Investment (PRI).
Corporate websites with sustainability pages can be useful for budding ESG investors but be wary when they don't contain enough detail to paint a complete picture.
The Second factor of ESG investing is the social aspect.
Factors such as company culture and issues that impact employees, customers, consumers, suppliers, the local community, and society at large all affect how ESG investors make their decisions.
The theory behind looking at how socially valuable a company is derives from the idea that companies that provide value to communities often grow and operate for long periods of time.
Not only might they provide a service that helps people, but they should provide a happy and healthy environment for their employees, making people want to work for them and a cultivate sustainable relationships with their suppliers.
ESG investors keep up with respected lists and annual rankings, including Fortune's Best Companies to Work For and Forbes' Just 100. Another good way to gauge how a company and its management is received by its workers is to read employee reviews on websites such as Glassdoor.com.
A big part of the social aspect of ESG investing is how companies interact with their communities, these communities can be anything from the employees that a company has or the people living around where they conduct their operations.
For example, the Nike Community Impact Fund (NCIF), In partnership with the Charities Aid Foundation of America, retail employees from Nike Community Stores in Chicago, Detroit, Los Angeles, New Orleans, New York City and Washington, D.C. — and employees from the Nike North America Logistics Centre in Memphis — award grants to local non-profits and schools that help kids unleash their potential through play and sport. This year, each city’s NCIF will award up to $50,000 in one-year grants, ranging from $5,000 to $10,000 each.
Image source: https://purpose.nike.com/ncif
This is just one of many examples of socially responsible and valuable investing.
When researching the social aspect of a specific company make sure to gather information on…
Employee treatment, pay, benefits, and perks.
Employee engagement and staff turnover/churn.
Employee training and development.
Employee safety policies, including those related to sexual harassment prevention.
Diversity and inclusion in hiring and in awarding advancement opportunities and raises.
Ethical supply chain sourcing, such as conflict-free minerals and responsibly sourced food and coffee.
Mission or higher purpose (or lack thereof).
Customer service friendliness and responsiveness.
Performance history for consumer protection issues, including lawsuits, recalls, and regulatory penalties.
Public stance on social justice issues, as well as lobbying efforts.
The 3rd and final factor of ESG investing is Corporate Governance.
This aspect is the most closely tied aspect to company performance and the day-to-day operations.
This step focuses on how a company is run, it looks at the relationship between management/profit objectives and how shareholder friendly a company is and how ell it can attract new investment.
But how do you even investigate that?
Simply put a company with strong leadership, made up of competent directors, that focuses on providing value to stakeholders (customers)...
When looking at Corporate Governance make sure to consider…
Executive compensation, bonuses, and perks, including whether executives receive large bonuses when they leave the company.
Compensation tied to metrics that drive long-term business value.
Diversity of the board of directors and management team.
Potential for conflicts of interest for the board of directors based on the directors' independence and whether they hold other board seats.
Proxy access, meaning shareholders' ability to put forth board of director candidates.
Whether a company has a classified board of directors, which denotes whether term lengths among board members differ.
Whether the company's chairman and CEO roles are separate.
Whether board votes are decided based on majority voting (winner receives more than half the votes) or plurality voting (winner receives the most votes).
Whether the company issues dual- or multiple-class stock.
Transparency of communication with shareholders.
The nature and outcome of lawsuits brought by shareholders.
Relationship and history with the U.S. Securities and Exchange Commission (SEC) and other regulatory bodies.
The key thing to note when looking at governance is the director’s incentives and willingness to see the company grow, lots of companies with affective growth implement policy such as making sure all directors own a significant number of shares in a company this, in turn, directly ties their performance to their personal value.
Companies that employ policies like this often perform well as they are run by people who care about making sure the business succeeds.
Many corporate governance details are found in sustainability reports but interested investors should also read the annual proxy statements they receive from the companies in which they own shares.
To research corporate governance attributes (including CEO pay) before buying a stock, you can access proxy statements on the SEC's website by searching for the filing type DEF 14A.
Instead of spending hours delving into reports and articles on companies a system for scoring and ranking companies for ESG investments has been developed.
This makes the whole process a lot easier, as instead of you doing the research the research is all done for you by professionals, but how does this work?
Who gives ESG scores and How is ESG calculated?
Scoring companies for investment opportunities is not a new thing, however, rating companies on the ESG criteria we previously discussed is, as more and more investors look to get into socially responsible investing, more and more companies have made improving the morality and sustainability of their operations a priority.
So how do we separate the good ESG investments from the bad, in truth there are many ways including doing the research yourself or spending hours on forums and talking to different investors and debating the subject.
The best a quickest and most popular way, however, is a simple scoring system developed by Morgan Stanley Capital International (MSCI).
MSCI is an investment research firm that provides stock indexes, portfolio risk and performance analytics, and governance tools to institutional investors and hedge funds.
Their ESG ratings have become one of the most popular indexes for rating different companies ESG criteria over the past 10 years, but how does it work?
An MSCI ESG Rating is designed to measure a company’s resilience to long-term, industry material environmental, social and governance (ESG) risks.
They use a rules-based methodology to identify industry leaders according to their exposure to ESG risks and how well they manage those risks relative to other companies in similar industries.
Their ESG Ratings range from leader (AAA, AA), average (A, BBB, BB) to laggard (B, CCC). They also rate equity and fixed income securities, loans, mutual funds, ETFs, and countries.
ESG risks and opportunities can vary by industry and company. The MSCI ESG Ratings model (shown below) identifies the Key Issues that affect an Industry or sector.
With over 13 years of live track history, they have been able to examine and refine their model to identify the E, S, and G Key Issues which are most relevant to an industry.
MSCI rate over 8,500 companies (14,000 issuers including subsidiaries) and more than 680,000 equity and fixed income securities globally (as of October 2020), collecting thousands of data points for each company.
What are the best ESG funds?
ESG investing can be either passive or active.
Active investing means that you are personally responsible and in control of all aspect of the investments you make, meaning that it is your own responsibility to manage the investment.
Passive investing involves handing over responsibility for the management of the investments to a 3rd party where you are not directly involved in its management, for example, investing in an ETF or mutual fund.
There are multiple ways to carry out ESG investing however the most popular is investing in an ESG fund.
ESG funds are not individual stocks.
They are a collection of multiple stocks grouped together. Buying into a fund rather than an individual stock can decrease risk since a fund holds shares of many companies rather than just one.
If one company represented within your fund goes out of business, the fund should weather it better than if you owned stock in a single company that went under.
These funds use the MSCI index to determine what companies to invest in and then create portfolios for investors based on a certain industry or sector.
Investing in an ESG fund takes away the work needed to create one for yourself, they act as a ready-made sustainable portfolio for you, and you are not limited to only invest in one, you can invest in as many or as little as you want, spreading your investment and therefore your risk.
But what are the best funds to buy into in 2021?
Below is a list of the top performing ESG funds, to find more information on each of these funds make sure to type in the Fund name to google.
Is ESG investing profitable?
ESG investing is a long-term strategy, as I have said before companies that provide actual value to local and global societies often are more sustainable investors as there is a lot of good will for the company.
With investors liking what the company are doing, employees happy to work for the company and governments and institutions happy to work with and help the company in unique ways due to its good reputation and good management.
Companies with high ESG scores will have excellent management team and effective practices which inevitably lead to increases in revenue and profits.
This logic is the basis for the idea that ESG invest is actually one of the most profitable strategies out there.
Companies that purely value profits often don’t succeed long term as when they fall on hard times, management and investors pull out as they are only interested in the money or return they where seeing.
Investors often follow the money, so if you can create a sustainable and strong company through focusing ESG criteria then your chances of survival are stronger as you will have the support and willingness of your staff and the board of directors to make the company work.
ESG investing is profitable, but like any investment or risk taking there is always a downside, due to the competitive nature of the markets and different industries some companies just do fail.
There’s no way to be 100% certain of success in any company or industry, so even though a company could be extremely sustainable and have a lot of good will going for it, it may just not work out.
The goal with ESG investing is to create a portfolio and strategy that is good an moral, as in the long run, that will provide more value and hopefully profit, than a short term and unsustainable investment.
It’s almost like ‘paying it forward’ or Karma, the idea that putting something good into the world will eventually come back around for yourself.
One key thing with ESG investing however is not to get clouded by the different criteria. At the end of the day businesses must generate profit and if they don’t, they fail.
It’s as simple as that, you could be investing in the most charitable, and responsible company out there but if they are not selling goods and making money, your investment will be worthless.
ESG investing in emerging markets.
ESG investing is now shaping how emerging markets and more importantly new companies are being formed.
As investors increasingly look for companies that demonstrate social responsibility emerging markets are striving to meet demand with new companies such as Tesla focused on Environmental sustainability.
Longevity is now the trend for investors and companies.
More and more companies have started to focus on employee wellbeing, more attention is being shown to charities that get involved or are owned by big corporations and as more and more mainstream companies start to ‘give back’, new and emerging companies are coming up with the same philosophy.
Why ESG investing is important?
ESG investing is important for several reasons.
While being an affective strategy for investors to make returns it also pushes more companies to consider how they can become more sustainable and provide value back to the world beyond just their product or service.
The constant struggle for companies to become attractive for investors, as they want to be able to grow, is forcing the hand of big corporations to take sometimes major steps to helping not only themselves but the global community.
They do this by either becoming more environmentally sustainable, helping local communities, and shifting their management style to better incorporate their employees.
Conclusion
ESG investing is widely regarded as the future way of looking at long term investments, as global focus shifts towards a more socially and environmentally conscious place naturally investing strategies will also follow suit.
Over the next few years we will see a shift in how companies operate towards a more ESG conscious business model.
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It’s similar to the journey in alcoholism recovery—both require a commitment to better choices and long-term benefits. Just as ESG investors look for companies that align with their values, individuals in recovery strive to build lives that align with healthier goals. Each step toward a sustainable portfolio or a sober lifestyle is a step toward meaningful change. It’s inspiring to see how conscious decisions, whether in finances or personal health, can create lasting impact.