Have you considered how your investment portfolio reflects your views? Do you wonder if a certain publicly traded company supports something you don’t believe in? Do you want to make your voice heard or have your opinion reflected in your investment choices? If you said yes to any of these questions, there are more options today than ever to consider! Thankfully, portfolio managers have listened and heard investors' voices.
ESG stands for Environmental, Social, and Governance. They are the three factors considered when creating an ESG portfolio, mutual fund, or exchange-traded fund. The fund isn’t based purely on the rate of returns or the size of the company. Yes, those metrics matter. However, the portfolio is focused on sustainability and ethical considerations.
Environmental – considers how a company is a good steward of our environment and addresses pollution, water usage, energy efficiency, reducing waste, and more in their business practice.
Social – evaluates a company’s policy on labor practices and worker rights, safety, and community involvement.
Governance – assesses the company’s leadership style, structure, C-Suite compensation, and transparency.
There are several ways that these investment options are created and offered to provide investors with choices.
First, a portfolio manager employs ESG filters to rate companies, then sifts through a wealth of qualitative and quantitative information to select the best companies to add to their fund. This is referred to as ‘active management’. The fund can be comprised of hundreds of companies to create a diversified portfolio. A diversified portfolio means there will be parts inside that may be performing very well, not so well, and other points in between. This style is to help manage overall risk, especially when the market is struggling. It’s a way to not have all of your eggs in one basket. Instead, it is more like a jar of seasoned salt, a blend of flavors.
Another way is sector-based. The fund is created to include only companies with a specific focus. Some examples include electric vehicles, battery manufacturers, alternative energies, water resources, and diversity/equity/inclusion. They could include US-based or foreign-based companies. Because these funds use only one focus or sector, there is a greater risk in investing in them. If the sector is struggling as a whole, the entire fund will likely reduce in value. However, there is greater flexibility and choice. With the sector-based options, you can buy many different sectors individually and decide how much of each sector you want to own, which essentially creates a diversified portfolio. The ups and downs of each sector will be more transparent. This process allows you to easily make changes to your overall sector composition.
Most investors like to compare their portfolio’s performance to a benchmark to monitor how well it is doing. Typically, investors like to watch the S&P 500, Dow Jones, or Barclay’s Aggregate Bond Index. ESG investing won’t exactly compare to those Indexes, though. Direct Index Investing, done through a specialized investment firm, allows an investor to buy most of an index and choose types of companies to not invest in. For greater understanding, portfolio managers will list a ‘tracking error’ percentage, indicating the expected difference between their portfolio and the chosen index. This will give investors an idea of the amount of positive performance they may be giving up by eliminating certain types of companies. By doing that, an investor is creating a custom ESG portfolio.
This leads to another option of ESG investing. An investor can choose to invest directly in an ESG Index. Many of the largest investment companies offer this type of passive option. An index is a list of predefined companies that provide a broad ESG diversification. An investor would want to understand how often the companies included are evaluated for worthiness. A positive to passive/index investing is lower fees, the trade-off is a lower level of management.
There are many things to consider when choosing to invest in ESG options.
Potential for long-term returns – ESG practices may be more resilient and perform better due to their evolving thought process and ethical practices.
Subjectivity – Each portfolio manager will employ a different research style, therefore, understanding their management philosophy is recommended.
Risk of ‘greenwashing’ by portfolio managers – Claiming they are choosing ESG-type companies without using a strong research process, which misleads investors.
Lower short-term performance – Investors may miss out on high-performing investments that don’t meet the ESG criteria.
Potential for higher fees - Due to the greater level of research, portfolio managers may charge a higher expense ratio, which reduces your rate of return.
The objective is to be aware of these things to make the best choices as you are building your portfolio.
Our world is changing at an accelerated pace, making it tough to keep up with it all. And much of it is centered around environmental, social, and governance impacts. While ESG investing has its unique challenges, it certainly offers investors the ability to feel more comfortable with their choices and the opportunity to align their investing with their personal values.