EVERYTHING YOU WANT TO KNOW ABOUT ESG INVESTING
WHAT DO ALL OF THE NAMES MEAN?
ESG, SRI, Impact investing, and more. While these terms are often used interchangeably, there are some subtle differences. Let’s strart by defining each. ESG stands for environment, Society, and governance. Three specific categories of consideration that are used to filter investments. Sri stands for socially responsible investing. This can be considered the umbrella term as it catches both ESG and any other criteria an investor may have like Weapons, tobacco, or alcohol. Impact investing takes either of these a step further as it intends to not just avoid investing in “bad” things, but it seeks to allocate investment dollars in a way that can cause direct change in our world.
For the sake of this article, we will mainly use the term ESG investing, and the concepts associated with it.
ORIGINS
If you thought that ESG investing is a recent 21st century trend, I wouldn’t blame you. Many people are just hearing about it for the first time. If you thought it came about in the late 1900’s when consumers first started to hear about going green, and Captain Planet was on TV, again, I wouldn’t blame you. But to get the real beginnings of ESG investing we have to go way back. 200 years back.
ESG investing gets it’s start with a fellow by the name of John Wesley. If that name rings a bell, you are correct, we are talking about THAT john Wesley. The founder of the Methodist faith john Wesley. How is he responsible for what is becoming one of the hottest trends in investing? Allow me to explain.
Wesley urged his practitioners to avoid the practice of making money at the expense of their neighbors. As a result, members of the faith refrained from making investments or forming partnerships with anyone who made their money through alcohol, tobacco, weapons, gambling, and a few more categories that made up the group of investments known as sin stocks. These prohibitions laid the groundwork for the idea of investing in ways that aligned with an individual’s moral and ethical compass. While these “sin stocks” are a far cry from the complex ESG investments available today, this is where our story starts.
Modern ESG investing started to take shape in the 1960’s as a generation became disenfranchised with the Vietnam War, racial inequality, and income disparity. Once that generation grew up, their activism led to labor movements and ultimately into corporate resolutions. As that generation gained wealth, the first ESG and SRI funds started to take shape using screens to filter out companies that were seen as unethical or counter to the investor’s beliefs. Throughout the late 20th century more ESG funds became available to investors as the fledgling industry started to gain traction.
GROWTH OF ESG INVESTING
As Millennials have started to gain wealth and invest, the popularity of ESG type investments has skyrocketed. As inflows pick up, the category is expected to reach $1 trillion by the year 2030.
Recent press releases by the Likes of Blackrock’s Larry Fink have worked to really shine a spotlight on the investment merits of the category which is serving to bring in dollars from investors who are seeking performance, and are not driven by the ESG criteria.
INVESTMENT CATEGORIES
As ESG investing has grown and evolved it has begun to enter different markets and categories of investments. While the initial foray onto ESG investment funds were primarily stock investments, funds now allow investors to position their funds into bonds, or real estate.
Green bonds have been gaining traction particularly in Europe, as governments offer increased incentives for companies to borrow money for green projects.
The bonds first arrived on the scene in 2007 with the “climate awareness bond” and have been booming ever since. In their first year the total amount of bonds issued was about $800 million. In 2020 that number had ballooned to over $250 billion. While many of the bonds are still issued by the World Bank, many other players are also beginning to enter the game. Most estimates expect that number to continue growing as the demand for the bonds still outpaces the amount available for investors to purchase.
Green bonds are generally asset-linked and backed by the issuing entities balance sheet. Thus they typically carry the same credit rating as as their issuer’s other debt obligations.
One of the biggest challenges to green bonds, is defining what constitutes a “green” bond. External review processes have emerged to help address this issue. While the process has improved there is still a wide variation in the external review process between different regions, and industries. The introduction of the Green Bond Principles by the International Capital Market Association in 2014 helped to standardize the process but it is still not a perfect process.
INVESTMENT APPROACHES
As of this writing the vast vast majority of investors looking for ESG investments do so by using either exchange traded funds, or mutual funds.
The benefit to these investment funds is the ease of use for investors. One click of your mouse and you can put your money to work in a diversified pool of stocks, bonds etc, that are under an ESG label.
The downside to these prepackaged funds, is that is difficult to impossible for the average person to tell what kinds of filters are being used to determine the investments inside the fund. How did the fund manager set their criteria for what companies qualify as ESG. Do you as an investor have any say in the matter or are you simply along for the ride.
GREENWASHING
Put simply, greenwashing is the ugly byproduct of ESG investing. You may not have heard this before, but Wall Street firms can be greedy. If there is a pie, they want their slice. And more often than not, they want the biggest slice.
As investors have shown increasing demand for Environmentally friendly investments, fund companies have been all too happy to offer options to help them achieve that goal. "Greenwashing” is the process of those funds being portrayed as more environmentally friendly than they really are. In general it is not done with bad intentions, it simply results from a discrepancy between what the fund company defines as green, and what you as the investor define as green.
When it comes down to it. The only way for an investor to be sure they are investing in green companies is to do the due diligence to actually look into the companies they are investing in. Doing that detailed homework will help you make decisions that align with your personal ethics. Take a look in particular at the companies business practices, not just their reports. In other words, look at what they do, not just what they say.
The best way to have total control over how ESG Friendly your investments are, is to actually get your hands dirty and select the specific companies you believe in. Putting together a diversified portfolio of ESG stocks that meet your personal criteria is no small endeavor, and as a result not many investors attempt it. Balanced Capital does this process for you, using our transparent selection criteria which you can read about in other posts on this blog.
PERFORMANCE
For years, it was believed by many that screening a portfolio for ESG merits would reduce the overall performance of your investments. In short, investing with your heart, would cost you. Turns out, new studies are coming on board that actually show the opposite. While I will stop short of writing anything specific about the performance of ESG investments, I will say, that you do not need to worry about sacrificing any investment performance if you want to embark down the ESG path. You have just as much potential for positive returns within the confines of ESG, as you do in traditional markets.
POTENTIAL FOR CHANGE
Whether you classify yourself as a full fledged environmentalist or you’re simply someone who tries to make sustainable choices, you care. ESG investing gives investors the opportunity to quite literally put their money where their mouth is and make investment decisions that back up their principles.
Experienced investors are likely familiar with what are known as proxy cards. The vast majority of investors throw these away before they even make it inside form their mailbox. If you’ve been guilty of throwing them out without reading them, or you are new to investing, let me explain what they are. Every year, companies have shareholder meetings and they vote on issues from board of director positions, to specific projects. Because most individual investors don’t live near where the meetings take place, the proxy card enables them to mark down their choices on the issues up for vote, and then elect someone who will be at the meeting to vote in their place. In a nutshell, what this means is that if you own shares of a company you actually have a voice, albeit a small one, in the decisions the company makes and you can help steer them in a greener direction.
The biggest power that individual investors have in company decision making does not come from proxy voting. It comes from the laws of supply and demand, and the method in which executives are paid. There are two things going on here;
CEOs and company executives are often paid in several ways but one of the largest ways is through performance based incentives and in most cases performance is tied to the share price of the company.
Supply and demand dictate that if investors sell a particular stock in mass they can push the share price lower. Conversely if investors buy shares they raise the price of the stock higher.
If you as an individual don’t like the way a company is behaving, you can sell the stock. You doing that alone will not have any effect on the share price. But if thousands of people or more do the same thing, as a group we can affect the price and push it downward. Pushing that price downward means management will likely face a reduction in their pay. Thus as a group, we have just provided company directors with a personal incentive to fix their behavior.
WHO IS IT FOR?
To be clear, ESG investing is not meant for everybody. I wish I could tell you it was, because I think it should be. But unfortunately we do not live in a perfect world. ESG investing is made for people who believe that their individual actions matter. ESG investing is for people who believe it is not ok to simply stand by and watch the world go by. ESG investing is for people who understand we have a problem, and they want to do everything they can to fix it.