Environmental, Social and Governance (ESG) investing is considered one of the most ethical ways to build an investment portfolio. With millennial and Gen Z investors appearing keen to align their values with their financial investments, brokers have tried hard to offer financial products that align with the so-called ‘ESG criteria’.
These criteria have become a set of standards by which ethical investors seek to follow.
The history of ESG investing
ESG trading has been around longer than you think. The issue with publicly listed companies and stocks was raised by Milton Friedman in 1970. Friedman coined the term ‘Shareholder Value Theory’, which characterised the behaviours of many listed corporations throughout this era.
Friedman claimed that listed companies had tunnel vision – a one-track goal to optimise financial returns for their shareholders. He believed that this Shareholder Value Theory caused many large companies to adopt a rigid approach to their operations, foregoing their environmental and social responsibilities in favour of chasing a quick buck.
Before Friedman’s theory, the previous decade threatened to usher in a new era of socially responsible investing. Following the Vietnam War, concerns grew for funds for university endowments to cease investments in defence stocks. 20 years later, companies deemed complicit in South Africa’s apartheid system were also given a wide berth by global investors. This alone led to the economic instability in the region, forcing the long-awaited collapse of the apartheid regime.
More recently, ESG screening has become an integral part of modern-day financial analysis, with investors conscious of the wider impact of short-term shareholder value.
What does ESG stand for?
If you are new to the concept of financial trading and investing, it's a good idea to familiarise yourself with the ESG criteria. It's a framework used to define the sustainability of an equity, based on a string of environmental, social and governance factors.
Multiple factors comprise the ‘Environmental’ element of the ESG criteria. The most prominent are strategies regarding climate change and energy efficiency. Climate change is an increasingly hot topic around the world. Ambitious targets have been set within the Paris Agreement and the UN Framework Convention on Climate Change. As governments agree on new regulations, this will have a knock-on effect on the supply chains and output of leading companies.
Companies that research and develop new strategies to tackle recycling and waste management, as well as integrating natural resources into everyday operations, will also curry favour with ESG-focused investors. Even traditional sectors such as the light industry may achieve strong ESG scores for overhauling their manufacturing processes and limiting the toxins involved or for improving the carbon footprint of their supply chains.
The ESG criteria is about more than just environmental challenges like cutting CO2 emissions, air pollution and waste management. It looks closely at social factors to determine how corporations treat their staff, as well as the dissatisfaction of their customers. Companies will be reviewed and rated based on the inclusivity of their programs and recruitment practices, taking into account the need for LGBT equality and racial diversity.
The social factors of ESG also take into consideration a company’s standing within its local communities. ESG scores will rate a company’s commitment to advocating social good, far beyond the limits of its own business or industry.
Governance factors carry equal weighting too, with significant emphasis on corporations with a diverse board of directors, as well as those which avoid high-profile lawsuits. Aside from the diversity of a company’s board, it’s the actions of said board that make a difference too. How does the company’s board and senior management commit to driving positive change?
Does the company lobby hard in the best interests of the wider society? Does the firm have strong, trustworthy links with industry regulators? Does the company have a history of maintaining an open, transparent relationship with its shareholders? The answers to these types of questions can help to nail down a company’s ESG score.
As time elapses, pressure is intensifying on companies from all angles to adhere to the ESG framework. Those stocks that demonstrate a commitment to moving with society are more likely to stand the test of time and provide long-term value for investors.
What types of ESG investments can I make?
There are four types of ethical investments you can look at add to your portfolio:
- Publicly traded ESG stocks
The most direct way to embark on socially responsible trading is to invest in companies that take their ESG responsibilities seriously. However, investing in individual ESG stocks brings its own challenges, as you're required to monitor equities closely regularly. It could be companies that are investing heavily in renewable energies or eco-conscious food producers that seek to limit the carbon footprint of human consumption or keep a tight rein on their supply chain efficiency. Social factors can also make a difference, such as gender diversity on the boards of major corporations. On the governance side, companies with defined and enforced ethical business practices are also looked upon favourably. Look out for stocks that register high ESG scores and ratings. We’ll cover what these scores and ratings mean and how they are calculated shortly.
- ETFs and index funds
It’s also possible to consider an Exchange-Traded Fund (ETF) that tracks ESG stocks, and indices that are specifically designed to monitor the performance of ESG stocks. The most notable indices for ethical investors include the S&P 500 ESG Index, the Morningstar Sustainability Indexes and the Dow Jones STOXX Sustainability Index. Fund providers will also offer different ESG ETFs, so it's best to review the key information document to understand its investment profile and any relevant risks.
- ESG-focused investment funds
Bloomberg revealed that over 140 ESG-focused investment funds were established in 2020. Each of which is focused on ethical companies that score highly based on the ESG criteria. It was said that these 140+ ESG investment funds alone contained assets worth upwards of $12 trillion, further demonstrating the underlying value and future potential in sustainable investing.
- Green bonds
A green bond is an alternative fixed-income instrument that allows you to invest in climate or eco-conscious projects. They often come with tax benefits, such as tax relief or even exemptions. An alternative to green bonds are blue bonds which focus solely on projects relating to marine life and oceans.
How are investments scored based on the ESG Criteria?
A company’s ESG score is a numerical rating of how it is seen to be performing, based on a plethora of environmental, social and governance factors. It’s important to note that these ESG scores are primarily based on publicly available information so if a company has environmental issues that aren’t disclosed and not known in the public domain, it will not be reflected in its ESG score.
There is currently no standardised approach for rating a company based on ESG factors. Multiple rating agencies provide timely assessments of companies’ ESG standing. The largest ESG rating providers are:
The MSCI ESG rating scores companies from AAA to CCC, based on their exposure to ESG risks. Those who scored AAA or AA are deemed industry pioneers; firms that make the most of the ethical opportunities in front of them. Those graded B through to CCC are considered to be at greatest exposure to ESG risks. The rating is derived from 37 individual factors, including carbon emissions, privacy, financial transparency and data security.
The Morningstar Sustainability Rating is one of the most reliable indicators of an ESG score. At Saxo Bank, we lean heavily on Morningstar’s ratings to measure portfolio-level risk from ESG factors. Morningstar is partnered with Sustainalytics to provide an accurate level of an asset’s material ESG risk. The scoring is on a ‘globe’ scale, with those exposed to the highest ESG risks given a ‘1 globe’ rating. Meanwhile, funds with the lowest ESG risks are given a ‘5 globe’ rating.
This agency focuses on a company’s industry-related exposure to ESG risks. It remarks on how a company is handling these risks. Their five-tier ESG Risk Ratings run from negligible through to severe, with low, medium and high in between. Those with a negligible ESG risk profile are deemed to be operating most ethically and sustainably.
Bloomberg has its own dataset comprising metrics and disclosure scores for a string of ESG stocks - over 11,800 in over 100 countries. Bloomberg's ratings cover a string of sustainability areas, including air quality, health and safety, diversity, shareholders' rights and many more.
The benefits of investing in ESG stocks
We’ve already alluded to the ethical benefits of adding ESG stocks to your investment portfolio, but there are other ways that ESG stocks and indices can influence your bottom line.
- Possibility to align your investments with your values
ESG investing is a way for investors to bring about positive changes and influence how companies do business and deal with all their stakeholders, not just the shareholders. Individually and collectively, investors have the power to sway companies into adopting more sustainable practices.
- Ability to keep pace with traditional investments
According to a 2020 Blackrock study, ESG indices have matched or exceeded their non ESG benchmarks since 2012. In 2019, the Morgan Stanley Institute for Sustainable Investing found that investments in ESG stocks and funds yielded similar returns to traditional funds between 2004 and 2018. In addition, Arabesque stated that S&P 500 firms in the top quintile for ESG scores outperformed those in the bottom quintile by over 25% between 2014-2018.
The risks of trading ESGs
The rising interest in ESG stocks brings with it a string of challenges for ESG-focused investors. In such a fast-paced world, there are many roadblocks for investors to negotiate to make ESG stocks a positive addition to your long-term investment portfolio:
- Greenwashing: Companies making unsubstantiated or misleading claims
One of the biggest issues for investors new to ESG stocks is the propensity for equities to make unsubstantiated or misleading disclosures about their operations. Too often, marketing materials are used to inflate a company’s ESG credentials, when the reality is somewhat different. There is an argument to suggest that companies can too easily label themselves as ‘green’ without having to dramatically alter the way they operate.
- Discrepancies in ESG ratings
There is a glaring lack of standardisation with ESG disclosures. Each ESG rating provider has its metrics and methodologies for determining its ESG ratings, resulting in discrepancies from one provider to the next. Recent research from MIT found that the correlation between ESG ratings were somewhat worse than conventional credit ratings. With ESG ratings, the correlation was 0.61 on average, compared with a 0.99 average for credit ratings - a considerable difference.
- A lack of standardised metrics makes it harder to pinpoint sustainable ESG stocks
Although the ESG criteria exist, the metrics involved in defining what makes a truly ESG stock remain somewhat vague. In some cases, they fail to define the difference between a company that’s actively looking to cut its carbon emissions from one that’s simply trying to safeguard its future against climate change. It won’t be long before clearer standards emerge, however. The EU has a Sustainable Finance Disclosure Regulation that requires asset managers to publicly disclose the 'adverse' social or environmental impacts of their investments. Similarly, the SEC is deploying its task force to define a clearer legal framework for companies to abide by.
How to get started with socially responsible investing
By checking stocks and funds’ ESG ratings, it’s easier than you think to build your diversified portfolio with a strong ESG profile. With more ESG-friendly stocks, mutual funds, ETFs and index funds available to trade than ever before, it’s possible to build an ESG-focused portfolio.
Alternatively, if you don’t wish to be self-directed, you could take advantage of our managed portfolios offering.
For example, the Brown Advisory Ethical Selection is a managed portfolio that focuses squarely on buying strong ESG stocks listed on the US stock markets. This managed portfolio has delivered a return of 85.38% since its inception in March 2019. As with many of our managed portfolios, there is a minimum investment required to get started. However, there is no minimum investment period with any of our managed portfolios. You can exit the portfolio at any time without paying a penny. Nevertheless, you should remember these portfolios are designed with long-term investments firmly in mind and are best suited to those willing to let their funds grow over several years.
If you’re someone that likes the idea of investing in sustainable and forward-thinking companies that are in total alignment with your moral compass, the first step is opening a brokerage account.
At Saxo Bank, our Saxo Account gives you immediate access to over 40,000 instruments, including thousands of ESG-friendly stocks and funds including mutual funds, ETFs and managed portfolios.