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."