The ABCs of ESG funds.
There’s the buzzy new acronym in finance. It’s ESG — Environmental, Social, Governance — a set of criteria intended to help consumers invest in ways that reflect their values, whether that’s supporting sustainable energy or not backing firearm companies. In recent years, this once small corner of finance has soared in popularity.
In 2020, about a quarter of the money flowing into U.S. stock and bond mutual funds was invested in ESG funds. That’s up from just 1 percent back in 2014, according to the investment research firm Morningstar. But for all its buzz, many casual investors don’t have a solid understanding of what exactly ESG is, how it works, and what to look out for before diving in.
What is ESG investing?
First, let’s start with the basics. ESG criteria are used to evaluate companies in three areas. Environmental criteria can grade companies on things like their use of renewable energy or their attitudes around climate change. Social criteria can cover a large range of issues, from workforce diversity to employee turnover and customer engagement. Governance criteria look at how well the C-suite is managing a company. Are executives raking in seven-figure bonuses while imposing a salary freeze for workers? Do they have policies ensuring their boards are inclusive?
That’s just a smattering of issues that are being considered when companies are scored. But what makes it even more confusing is that there’s still no hard-and-fast rule for what’s considered ESG and what’s not, says Kimberly Griego-Kiel, the head of Horizons Sustainable Financial Services in Santa Fe, New Mexico. That’s why it’s crucial for investors to do a little bit of their own research, she said.
“Honestly, there are a number of folks in the industry who are slapping on an ESG label — and maybe excluding a few things from their fund — and calling it ESG,” Griego-Kiel said.
ESG becomes mainstream
Socially responsible investing has changed significantly since Griego-Kiel started in the sector 23 years ago. It started with a focus on excluding “sin stocks,” like tobacco or alcohol companies, from portfolios, and grew to also screen out companies with management issues to protect shareholders.
It’s become much more sophisticated. There’s a new push to invest in companies that have good environmental or social policies. And there’s a new wave of shareholder activism, where investors are demanding companies improve on ESG standards. (That played out dramatically this year at ExxonMobil, where an alliance of activist investors took on the oil giant and installed three directors to its board in order to steer the company in a greener direction.)
Firms specializing in sustainable investing also have tools that can precisely tailor portfolios so that they align with a client’s specific interests, Griego-Kiel said. “If a client is a vegan, we can really dive down and exclude anything that would harm animals, like companies producing leather products, for example,” she said. “We have clients who don’t want to own any big banks or pharmaceuticals, so we exclude those.”
Some of the most popular and accessible ESG funds are ETFs or mutual funds designed to perform like a large index (like the S&P 500) but screen out the worst offenders, like big tobacco or oil. Billions are flowing into these funds and that number is projected to rise over the next few years.
“I think the climate crisis is pushing this forward in a lot of people’s minds,” Griego-Kiel said. “And I think the last two or three years, the social justice issues have too.”
According to a 2019 survey by Morgan Stanley, 85 percent of people expressed interest in some level of sustainable investing — affirmation that ESG “has entered the mainstream and is here to stay,” the investment’s chief sustainability officer said.
The movement’s also gaining steam because data shows investors aren’t sacrificing on returns. At least during the pandemic, ESG funds outperformed their traditional counterparts, although that’s largely because of its low exposure to oil, which plunged as Covid-19 spread across the globe.
Still, ESG funds remain fairly uncommon in 401(k) plans, Griego-Kiel said. That’s because of federal limitations, which the Biden administration seems interested in winding back as a growing number of employees call for sustainable options.
Some tips for newbies on ESG investing
For those who have a financial advisor, Griego-Kiel recommends asking about their investment process and how they determine the sustainability of those investments. And if they’re considering mutual funds, look into the fund’s holdings. You can do that by digging into a fund’s prospectus, which lays out its investment objectives and strategies, or doing a quick search online.
“You can find the top-10 holdings of a fund pretty easily online,” says Sonya Dreizler, a consultant who has worked with companies and advisors on their ESG practices. “Sometimes a client will find things in there that they’re very opposed to and wouldn’t have known about until they looked inside.”
Dreizler also recommends checking out a tool created by the nonprofit As You Sow, which allows users to see if the funds they’re invested in have fossil fuel holdings, weapons holdings, and more.
“You’re going to find a lot of things that are labeled green or environmental or sustainable and we haven’t gotten to the point yet where there’s much-enforced regulation around naming,” Dreizler said. “So just because a mutual fund or ETF is called ESG and has a picture of a tree on their website, that’s not enough to know that it will match your values.”
For investors interested in adding a sustainable option to their company’s 401(k), Griego-Kiel says the best thing you can do is to go to your employer and ask. Employees are becoming more and more vocal about wanting to direct their money into companies and causes they can get behind, and employers are listening, she said. Although the shift has been slow. She often sees one or two ESG options in a retirement plan now, “when 20 years ago I didn’t see any,” Griego-Kiel said.
The bottom line with ESG is it’s a great way to put your money where your mouth is — if you’re willing to do a little research to find the best options for you.
