What Is ESG Investing (And Why Is It Becoming Such A Huge Trend)?

What Is ESG Investing?

An ESG investment is an investment in companies with high quality Environmental, Social, and Governance (meaning corporate leadership) practices.

As a consumer, you have three primary ways in which you can influence a corporation's decisions. You can choose to buy or avoid their products, which influences their profitability. You can also choose to praise or criticize them in a public setting, which influences their reputation. Finally, you can also choose whether or not to invest in them, thus influencing their stock price. This third option is ESG investing.

Over the past few years, ESG investing has gone from a niche investment strategy to a trend that’s surging in popularity both within the United States and abroad.

According to a report recently published by Morningstar, the number of ESG index funds have doubled in the past three years. As of June 30th, 2020 there are 534 ESG index funds with a collective $250 billion dollars of investment.

In the same period of time, the United States, which has historically lagged behind Europe in its adoption of ESG investing, has nearly doubled its representation in the global ESG index fund market. It has gone from representing only 13% of the global market to 20%.

Not only are investors moving towards ESG investing, they are also moving away from investments with high negative impacts on social and environmental issues. According to a 2018 report on clean energy investment, a growing movement of investors representing more than $6 trillion dollars have reduced or completely eliminated their fossil fuel investments over the past few years.

What Are The 3 Types Of Issues That ESG Deals With?

As mentioned previously, there are 3 main categories of ESG Investing. They are environmentally responsible investing, socially responsible investing, and responsible governance investing.

Environmentally responsible investing takes into account how a company's policies address environmental issues such as climate change, clean energy, and water quality. An example of this is the SPDR S&P 500 Fossil Fuel Reserves Free ETF (SPYX). SPYX is an investment fund that tracks the S&P 500 index, but excludes any companies with fossil fuel reserves.

Socially responsible investing covers a wide variety of social issues, including quality education, affordable housing, disease treatment, human and labor rights violations, and good health and nutrition. Socially responsible investing targets companies that have far-reaching positive effects on social issues both in local communities and nationwide. The Fidelity MSCI Consumer Staples ETF (FSTA) is a great example of a socially responsible investment fund. It tracks an index made up of a high percentage of companies that generate a majority of their revenue from producing or selling products and services that meet the highest nationally recognized standards of health and nutrition.

Finally, responsible governance investing means investing in companies with ethical leadership practices. Some of the issues that responsible governance takes on are fair executive compensation, corporate accounting practices, board independence and diversity, and shareholder rights. One example of this is the SPDR SSGA Gender Diversity Index (SHE). SHE was created by ranking the 1,000 largest companies in the U.S. by the ratio of women on their board of directors and in executive positions. Only the top 10% of the companies with favorable ratios were included in the index fund.

These are all examples of different ESG funds that allow investors to positively contribute to the causes they are passionate about while building towards their own financial goals at the same time.

Whether you care about preserving the environment, creating a world with better nutrition, or supporting women-led companies, you can contribute to these causes and create a better financial future for yourself at the same time.

Why Is ESG Investing Becoming Such An Important Investment Strategy?

ESG investing started as a movement led by mission-driven institutions and advocates for social and environmental issues. However, it’s gaining incredible momentum because the question of whether or not to use ESG portfolios has recently become more than just a moral question. Choosing to not use ESG portfolios has become a decision that could come with real financial risks.

Let’s take a look again at the SPDR S&P 500 Fossil Fuel Reserves Free ETF (SPYX). Large swaths of investors are realizing that when carbon emissions are constrained, fossil fuel companies with carbon reliant assets such as coal plants and offshore oil rigs will become financially stranded, leading to lower profitability and stock prices.

This issue is not only a hypothetical scenario. We are already seeing fossil fuel company stocks start to underperform and ESG funds in general beginning to outperform their non-ESG counterparts. Here are a few examples:

From December 15th, 2015 to September 18th, 2020, SPYX has outperformed the regular S&P 500 index by 4.87%. An even larger performance gap can be seen with Vanguard's premiere ESG fund, ESGV. From September 28th, 2018 to September 25th, 2020, ESGV has outperformed Vanguard’s Total Stock Market Index Fund by an incredible 9.05%!

Finally, maybe the most shocking example of a performance gap between ESG and non-ESG investing was found in a 2018 study by the Corporate Knights, a financial information products company. In the study, they examined what happened when the New York State Common Retirement Fund, the third largest pension fund in the United States, failed to divest from fossil fuel companies:

"The New York State Common Retirement Fund (NYSCRF) would be an estimated $22.2 billion richer had it decided to divest its fossil fuel stocks ten years ago.... That works out to more than $19,820 for each of the fund’s 1,122,626 members and retirees, an amount that would have covered more than 25 percent of the costs from 2012’s climate change fuelled Superstorm Sandy."

Please keep in mind that past performance is not a guarantee of future performance, and your specific returns may vary. We continuously reiterate to our clients that investing in a fund just because it performed well in the last quarter or year (aka chasing returns) is never a good strategy. However, this recent shift towards higher performance from index funds containing companies with good ESG practices does appear to be correlated to a few major underlying trends, including the shift towards renewable energy, consumers becoming both more environmentally conscious, and an increase in health-consciousness in recent years.

Is ESG Investing A "Feel Good" Strategy, Or Does It Actually Make An Impact?

ESG investing makes a real impact because it affects one of the most important metrics of success for large companies: the price of their stock. When a company's stock moves up or down, it has major consequences for the company as a whole, but especially for its leadership and decision makers because a large portion of the leadership’s compensation comes in the form of stock ownership.

Jeff Bezos' base salary in 2019 as CEO of Amazon was only $81,840. In fact, it has only been $81,840 since 1998, the year after Amazon went public. He didn't become the world's richest person with a net worth of over $100 billion by having a base salary in the millions or billions. He did it by having his compensation come in the form of Amazon stock, of which he owns over 55 million shares.

The net worth of corporate leaders and decision makers is largely tied to the value of the companies that they run, for better or worse.

To illustrate this further, each time Amazon's stock price decreases by just one dollar, Bezos loses 55 million dollars of net worth and vice versa.

One of the primary functions of a corporation is to generate as much value as possible for its shareholders, of which corporate leaders make up a large portion. The main way that a corporation does this is by doing whatever it can to drive up it's stock price.

A company's stock price is largely a factor of demand for that stock. High demand drives the price of the stock up, while low demand drives the price down. When large swaths of investors choose not to invest in certain companies because of their environmental or social policies, the demand for and therefore the price of those company's shares goes down significantly. This in turn has a huge negative impact on the net worth of the leaders of those companies.

Imagine that you are the CEO of a major energy company. You have to decide whether your company continues to utilize fossil fuels, or make the expensive switch to renewable energy.

On the one hand, you have the public petitioning for renewable energy to reduce climate change inducing CO2 emissions.

On the other hand, you have the shareholders of your company (including yourself). They are worried that a shift away from fossil fuels, which has been profitable for a long time, could negatively affect the company's value and their net worths.

Obviously this is a very simplified look at a complex issue, but this is a decision that leaders in the energy sector have faced for many years.

ESG investing is powerful because it creates a large financial incentive for corporations to ethically align their actions with the wishes of consumers.

In this example, if the company didn't switch to renewable energy they would likely see a decrease in the demand for their stock because ESG investors would exclude them from their portfolios. This makes it much easier for the CEO to listen to the petitions of the public for renewable energy because that decision would also benefit the company's shareholders.

Is ESG Investing Right For You?

If you are someone who is passionate about environmental or social issues, then ESG investing is a great way to contribute to these issues.

When you invest in an ESG portfolio, you’re telling corporations the causes that you truly care about in their own language: dollars and cents.

Explore Our 10 Low-Cost Diversified ESG Portfolios!

At Abundo, we believe strongly in helping our clients pursue their passions. Because of this belief, we created 10 unique ESG portfolios built around different environmental and social causes that our clients have told us they care about, such as Clean Energy, Gender Equality, Minority Empowerment, Affordable Housing, and Disease Eradication.

All of our ESG portfolios are built with our core investing principles of using low-cost, diversified, highly liquid index ETFs, while screening for ETFs centered around the specific causes that our clients are passionate about.

If you’re interested in seeing how you can make an impact with ESG investing, go ahead and schedule a free discovery session with us. In this session, we can further explore our ESG investing options with you as well as review your financial situation and goals.