ESG investing has become quite popular in the last few years, but what is it? ESG stands for environmental, social and governance, and it’s a type of investing that focuses on investing in those three factors. ESG investing may also be called social responsibility investing or social impact investing because of its emphasis on trying to do good with your investments.
But critics of ESG investing say it’s become popular in recent years because Wall Street needs a new revenue stream. They say all the practice does is create a new way to charge investors for the same old companies, now gussied up under the guise of being good for the world.
Here’s how ESG investing works and whether it could be a good fit for your portfolio.
What is ESG investing?
Proponents of ESG investing focus on three key features of companies to guide their investment decisions. They then invest in companies that demonstrate these values and divest, or sell, companies that don’t meet these criteria. These three areas are:
- Environmental – These companies focus on environmentally friendly technologies or mitigating their impact on the environment by investing in green infrastructure. These companies may also emphasize how humanely they treat animals and use natural resources.
- Social – These companies emphasize healthy social dynamics, respecting racial, gender and sexual diversity, and take care of human stakeholders through fair pay, for example. They also work with other people and companies that respect these values.
- Governance – These companies emphasize how they are governed, including the structure of executive compensation, objective reporting to their shareholders and other stakeholders, and how they organize the board of directors fairly.
Many fund management companies, including those that create mutual funds and exchange-traded funds (ETFs), analyze publicly traded companies on these criteria and construct ESG funds using their stocks. The publicly traded companies need to meet certain criteria, which are often evaluated by third-party analysts, to be included in the funds.
Even individual investors can evaluate publicly traded companies with the help of analysis tools from Interactive Brokers, which offers a sophisticated third-party ratings system.
And returns from ESG investing? Some research suggests that investing in socially responsible companies may actually help your returns, not hurt them. But other research suggests the opposite: that investors must give up at least some level of returns to invest in ESG-friendly companies.
Regardless, critics of ESG argue that strong results from an ESG strategy are really more about the underlying companies doing well than the ESG factors themselves driving outperformance. Littered among the top holdings of ESG funds are many of the last decade’s top tech stocks. These kinds of companies could have done well regardless of their ESG credentials, critics say.
Investors thinking about investing in ESG stocks or funds should consider the following issues when evaluating whether factoring ESG into their investment portfolios makes sense.
4 key concerns with ESG investing
The promises that ESG can help change the world are big, and unfortunately those promises are probably bigger than what socially responsible investing can actually deliver. Here are four major concerns with ESG investing and why it may not be the cure-all that’s been promised.
1. You may be paying more to own the same companies
One of the most obvious problems with ESG funds is that they charge a higher expense ratio for what may end up being the same companies in other major indexes or funds. Take the iShares ESG Aware MSCI USA ETF (ESGU) from BlackRock, one of the leaders in the fund industry.
This popular ETF has about $25 billion under management. Its largest positions include Apple, Microsoft, Amazon, Tesla and Nvidia, comprising about 20 percent of the fund. As its prospectus says, the fund owns no companies involved in controversial weapons, nuclear weapons, civilian firearms, tobacco, thermal coal or oil sands or that are violators of the UN Global Compact.
Sounds nifty, right?
Now, look at what’s in the Vanguard S&P 500 ETF (VOO), which is based on the Standard & Poor’s 500 index and includes hundreds of top American companies. The top eight companies include Apple, Microsoft, Amazon, Meta (formerly known as Facebook), Alphabet, Berkshire Hathaway, Tesla and Nvidia. The stakes in these companies total about 26 percent of the whole fund.
These funds have huge overlap in their top positions, where a huge portion of the fund is held. But ESGU charges an expense ratio of 0.15 percent, while VOO asks 0.03 percent. For every $10,000 invested, that amounts to a difference of $12 annually. It’s not huge in absolute terms, but it adds up and other fund companies may charge more for their variation on the ESG theme.
The backstory: The fund industry has seen shrinking fees for years, as competition has heated up. ESG is an attractive marketing hook because fund managers can boost their fees.
2. Are these companies really doing “good?”
Do the firms among the top holdings in the ESGU fund surprise you? Do Amazon, Microsoft and Nvidia tout themselves as socially responsible investments? At least Tesla claims to…
And it might be a similar issue with stocks in other funds. Take another BlackRock fund, the iShares ESG Aware MSCI EM ETF (ESGE), which invests in emerging markets companies. It includes shares of Lukoil and Gazprom, both Russian oil and gas companies. These don’t sound like what people think of when they’re investing in environmental companies.
So yes, while a fund’s investments may not have specific characteristics such as being engaged in controversial weapons or thermal coal, they may not be all that green-friendly, either.
3. Not all ESG funds are the same
And that leads to a further point: While many funds may say they include ESG stocks, you won’t be able to judge at all unless you look closely under the hood. Even then, it’s tough to know which businesses a firm is actually involved in, since they’re often large and diverse.
BlackRock’s iShares at least acknowledges which specific kinds of companies aren’t represented in the fund. And that’s a good starting point. From there you can look further at the holdings to dig into what the fund owns and how much of it.
Some funds may own certain kinds of companies that they think are not inconsistent with an ESG mandate. For example, tobacco stocks that may be excluded from some ESG funds may score very well on sustainability metrics and be included in other types of ESG funds.
4. Divestment from non-ESG stocks doesn’t solve the problem
ESG proponents suggest that divesting their funds or portfolios from companies that don’t meet the mandate will help, ultimately, put those companies out of business. They see it as a kind of shareholder activism, where investors vote with their dollars. The reality is more complex.
Divesting non-ESG stocks from a portfolio or not lending to them may raise their cost of capital, making it more costly for them to do business. But if the divestment puts downward pressure on the stock, it actually increases the potential return to those who don’t invest according to ESG principles. Similarly, if it costs more for a company to raise debt from a bank or from other lenders, it means those investors are getting a higher return. So, perversely, ESG investing principles may be raising the prospective future returns of other kinds of investors.
Divestment may make investors feel like they’re not profiting from a social ill but doing so is like pretending the moon will go away because you’re not looking at it. More effective solutions include outlawing or regulating the product, or making it cost-prohibitive to produce.
Is ESG investing right for you?
ESG has caught the investing public’s fancy, in part because it promises a relatively easy fix to companies that profit by producing things that may be socially unproductive. But investors should consider whether ESG funds really achieve that goal and at what cost. Behind the push to ESG funds are many fund managers that are looking to profit from the funds’ higher fees.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.