What is ESG investing?

Written by Rick Welch

ESG investing or socially responsible investing involves the consideration of environmental, social and governance factors alongside traditional financial analysis.  As a young investor in the 1970’s, I learned that socially responsible investing involved the avoidance of the sin stocks, which were a grouping of companies in the alcohol, tobacco, gambling, adult entertainment and defense industries. The implied social benefit then was to support only socially responsible companies at the expense of those in sinful industries.  Fast forward to today and ESG investing is about far more than the companies or sectors which are excluded, rather ESG factors, when integrated into investment analysis and portfolio construction may offer investors a better method of assessing the quality of a company’s management, culture and operational risk profile. The focus now is on identifying those companies that promote and adhere to the highest standards in environmental, social and governance functions as a regular means of doing business. Environmental categories often include climate change, natural resource use, water sustainability, reduced carbon emissions, global renewable energy solutions and waste management. Social categories include human rights, labor relations, product safety, community impact and workplace health, safety and diversification.  Governance categories include ethics, shareholder rights, executive compensation and public policy. The use of ESG criteria can help investors find companies with values that match their own. While the concept of socially responsible investing makes sense, we are left with one important question we must answer. As investors, will we have to sacrifice performance in order to invest with our conscience?

Investors can choose from over 500 mutual and exchange traded funds (with total assets over $3.0 trillion) if they would like to add a social responsibility component to their portfolios.  There is a broad range of ESG indexes for investors seeking a diversified benchmark comprised of companies with strong sustainability profiles. The MSCI KLD 400 Social Index (KLD) “is a capitalization weighted index of 400 US securities that provides exposure to companies with outstanding ESG ratings and excludes companies whose products have negative social or environmental impacts. Companies are chosen for inclusion in the index based on ESG performance, sector alignment and size representation.” The top five holdings in KLD are Microsoft, Facebook, Alphabet, Visa and P&G. Sector weightings of KLD are similar to the S&P 500 with overweight ratings on Information Technology and Communication Services and underweight ratings on Health Care, Financials and Energy.  On the matter of investment returns, when viewed over 1-year, 3-year and 5-year periods, the performance of KLD is generally better that of the S&P 500. In particular, for the period of 2014-18, KLD with an average annual return of +8.53% beat the return of +6.67% for the S&P 500.

Is it really possible that an investment in an index comprised of socially responsible companies could outperform the broader market?  Of course it is. May be the answer lies in the fact that companies with the highest ESG criteria score might also be the best run and most profitable companies. The same companies that are industry leaders with management teams that are forward-thinking, skilled at anticipating and mitigating risk and less likely to take shortcuts to boost short-term results at the expense of long-term opportunities. We now know that the pursuit of social and environmental goals can promote sustainable and attractive profits over the long-term. It would appear then that a corporate structure that embodies social responsibility may also be one well positioned for success.