ESG investing: what it is and how it works.

Although the performance of their portfolio is a primary consideration for most investors, the appeal of responsible investing is steadily gaining ground around the world. If you care about issues like climate change, employee satisfaction and gender or racial diversity on a company board, ESG investing might be just for you. Even if your key concern is boosting returns, you should still get familiar with ESG criteria. This could help improve the long-term financial performance of your investments as you may spot emerging risks and threats earlier than those who ignore ESG.

ESG investing stands for a strategy that incorporates environmental (E), social (S) and corporate governance (G) factors besides traditional financial measures. This approach is not only for responsible investors, it can help anyone make better-informed choices as it goes far beyond the traditional risk and return concept. Integrating ESG factors into your investment strategy may improve long-tail risk management and long-term financial performance.

The main ESG risk factors include climate change, labor-management and corporate governance standards. As new sustainability challenges are rising globally, investors are constantly screening emerging risks, such as demographic shifts, regulatory changes, extreme weather events and privacy issues.

ESG investing

Invest responsibly

ESG investing is often used interchangeably with other similar approaches, such as socially responsible investing (SRI), value-based investing, sustainable investing, impact investing and ethical investing. While they all focus on sustainability, there are some subtle differences. 

Impact investing differs from ESG in that investors pick their assets with the intent of making a positive and measurable impact. They want to help a business or an organization tackle global problems, like rising inequality, racism or climate change. Impact investing strategies are typically implemented in the form of private equity or debt.  ESG, in turn, means investing in companies with good environmental, social and governance practices. ESG investors are hoping to find opportunities or eliminate risks that cannot be identified through traditional financial and technical analysis. 

Socially responsible investing means selecting investments that are in line with your values and principles. Investors apply both positive and negative screenings. For example, you want to avoid investing in ventures that cause environmental damage (i.e. airlines or oil companies) or you look to support firms, which use clean energy or have a diversified board. 

ESG investing

A historical look at ESG

Is ESG investing a brand new approach? No, it isn’t. The first socially responsible investing practices trace back to centuries, when certain investors started to avoid investing in so-called ‘sin stocks’, such as slave traders, tobacco and alcohol producers or gambling companies. Later, military contractors and firms that use sweatshops or child labor were added to the list of excluded companies. The catalogue of sin stocks has been continuously expanding and changing, the latest additions are pot and porn stocks. Pot stocks are the shares of companies with exposure to cannabis. 

The year 2004 marked an important milestone and laid the foundations of responsible investing as we know it today. That year, former United Nations Secretary-General Kofi Annan invited the world’s biggest institutional investors to work out the Principles for Responsible Investment. The fist result of the initiative was a report entitled ‘Who Cares Wins,’ which introduced the term ESG and mapped out the key aspects of ESG investing. 

The six Principles for Responsible Investments, launched in 2006 on the New York Stock Exchange, aim to implement and promote ESG issues through the whole investment decision process. Since the launch, the number of signatories has grown from 100 to over 3,000. 

There has been a steady increase in assets in sustainable funds over the past few years, research firm Morningstar said in its quarterly Global Sustainable Fund Flows report. Record inflows boosted the value of global ESG fund assets to just shy of USD 2 trillion at the end of March 2021. Europe alone accounted for over 79% of global sustainable fund assets mainly due to its favorable regulatory environment.

In addition to launching new sustainable funds, asset managers convert some of their existing funds into ESG funds. Sometimes they even change the name of their funds to make their sustainable nature clear to investors.

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