3 Approaches to Environmental, Social, & Governance Investing
Many investors want to build a more ethical portfolio that reflects their social and environmental values. Enter environmental, social, and governance (ESG) investing. Also known as socially responsible investing, ESG investing considers non-financial factors, such as racial justice, gender equality, environmental performance, and animal rights in addition to traditional financial performance.
According to the 2021 Natixis Global Survey of Individual Investors, ESG investing appeals to mainstream individual investors but is most popular among Millenials. Of respondents, 27% of Millenials said they invest in ESG, compared to 20% of Gen Xers and 18% of Boomers.
“As ESG becomes more widely adopted and investors learn more about the different kinds of ESG investments, interest in ESG investing is growing rapidly, reinforced by positive returns from these strategies,” explains Nathalie Wallace, Global Head of Sustainable Investing at Natixis IM. “With governments, nongovernmental organizations, and private companies all showing increased commitment to ESG goals, these strategies can enable investors to pursue superior environmental and social outcomes and the financial performance they expect.”
Will My ESG Investments Have Lower Returns?
Unmitigated risk can lower investment returns and the same could be said for unmitigated ESG risk. Proponents of ESG investing often point out that companies with strong ESG performance can benefit their bottom line, but this isn’t always the case.
How Do I Get Started With ESG Investing?
According to the Natixis study, one of the biggest hurdles to those interested in ESG investing is not knowing enough about it or not having options through their advisors. However, ESG investment funds are becoming more and more prevalent.
There are three general approaches to ESG investing.
Socially Responsible Investment Funds
One easy way to get started is to purchase mutual funds or exchange-traded funds (ETFs) with ESG criteria. When taking this approach, it is vital to consider the fund fees, ESG criteria, and investment risk. Some investment firms, such as Invesco and Vanguard, offer options with expense ratios of 0.2%, which is quite low. More actively managed funds have higher expense ratios, which can add up.
Unfortunately, some investors might not find the ESG filters strong enough. In fact, some of these ESG funds closely resemble funds with no social and environmental filters at all. Such ESG funds screen for exclusions by product category and company conduct rather than prioritizing ESG high performers.
For example, Invesco has ESG funds, the Invesco ESG NASDAQ 100 ETF (QQMG) and its ESG NASDAQ Next Gen 100 ETF (QQJG). These ETFs exclude corporations that don’t meet Nasdaq’s ESG criteria and companies involved in alcohol, cannabis, controversial weapons, gambling, nuclear power, oil and gas, and tobacco are filtered out. Companies in the ETF must also receive a Sustainalytics score of under 40 on a 100-point scale for ESG risks.
QQJG is similar to Invesco’s Nasdaq Next Gen 100 ETF (QQQJ), but its top holdings and weighing are slightly different. When QQJG launched, 10 companies in the Nasdaq Next Generation 100 Index didn’t qualify for inclusion in the fund. Of them, four were casinos and three were pharmaceutical companies. In addition, Beyond Meat was excluded from the fund for having a Sustainalytics score above 40, thus disqualifying it.
Some of the green rating systems have been under scrutiny lately. Sustainalytics, for example, ranks companies on ESG risk and how a firm’s economic value could be at risk, rather than actual ESG performance. As a result, a highly polluting company could get a relatively high rating if their polluting activities are seen as well managed and not hurting the financial performance of the company. However, green investors would most likely rather avoid investing in highly polluting companies altogether.
The NAACP Minority Empowerment ETF (NACP) takes a slightly different approach by tracking the Morningstar Minority Empowerment Index of companies. This gives investors access to U.S. large and mid-cap stocks for companies with strong racial and ethnic diversity policies in place, empowering employees irrespective of their race or nationality. The fund was created in 2018 and has an expense ratio of 0.49%.
Impact Investment Managers
Another common ESG investment approach involves investing in companies that have high ESG performance. According to the Global Impact Investing Network, impact investing is “investments with the intention to generate positive, measurable social and environmental impacts alongside a financial return.” There are numerous ways to invest that impact the world in different ways.
For example, Newday Impact has investment portfolios that address a variety of issues including ocean health, climate action, and protecting biodiversity. This certified B Corporation charges 0.75% of assets under management plus a $20 annual maintenance fee. Newday Impact uses a mobile app with customized results depending on impact goals and investment risk tolerance. Check out Earth911’s regular conversations about ESG investing with Newday Impact CEO Doug Heske.
Another option is Farmland LP, which purchases conventional farmland, converts it to certified organic, and implements other sustainable farming techniques. The target investment internal rate of return is between 9% and 11%.
According to its website, “Our team leverages decades of combined experience to transform conventional commercial farmland into a more profitable regenerative landscape. Investors gain exposure to two markets: farmland and organic food.” However, the fund has a minimum investment of $50,000 and has a holding period requirement of 1 to 7 years, making it out of reach to many investors.
Individual Stocks or Select Industries
Another option is to select individual stocks, however, it can be very time-consuming to research individual stocks in an attempt to pick top performers. Also, owning just a few stocks means less diversification and therefore, greater investment risk. Therefore, investment experts often recommend buying quite a few individual stocks, perhaps 25 or more.
By contrast, investing in a particular industry means a bit less investment risk than individual stocks and there are funds with stocks in a variety of companies within a sector. For example, an investor might invest in the electric vehicle (EV) industry to promote cleaner transportation. Keep in mind that diversification reduces investment risk, so sticking to one industry can also be inherently risky.
For example, on a Tesla investor call in late January 2022, Elon Musk made comments about how supply chain shortages could impact new EV model rollouts. The next day, Tesla stock fell 11.6%, and other EV manufacturers, including Rivian and Lucid Motors, saw similar losses.
An alternative is to invest in more diversified green funds. For example, the Shelton Green Alpha Fund (NEXTX) seeks “to achieve long-term capital appreciation by investing in stocks in the green economy.” The fund seeks companies that help economies adapt to, solve or reduce the effects of systemic environmental and economic risks.
NEXTX has stocks from companies of all sizes and numerous sectors, increasing fund diversity. Some of the top holdings include Moderna, Tesla, Vestas Wind Systems, Jinko Solar, and Brookfield Renewable Corp. The fund has a minimum investment of $1,000 and an expense ratio of 1.16%.
Start Small, Learn With the Herd
ESG investing is clearly a long-term trend. In 2021, more than twice the amount of capital flowed into ESG stocks and funds compared to 2020. As the economy transitions to renewable, sustainable approaches to making, shipping, selling, and supporting virtually everything we use or consume, there will be plenty of time to identify and understand trends you want to follow. While there will be ups and downs, the green economy is a better bet than its dirty, fossil fuel-powered predecessor.