What is ESG? 

ESG stands for Environmental, Social, and corporate Governance. They represent three categories that are commonly analyzed when looking to invest in a company or a fund. One common phrase that might sound familiar is “aligning your investments with your values.” Many financial advisors and institutions use that phrase to lead into a discussion around an investment portfolio that has incorporated ESG factors. More recently, ESG has been viewed as a material risk factor. Ultimately, this means that regardless of whether the portfolio aligns with your values or not, incorporating ESG may mitigate certain risks within your portfolio. ESG isn’t just for “tree huggers”; it is becoming more and more mainstream as people are looking to utilize it to make a more robust portfolio. 

What is included in ESG?

ESG includes dozens of criteria that fall under the three main categories. Common examples within the Environmental category are climate change vulnerability, emissions & energy use, and raw materials & other resource use. Common examples within the Social category are human capital management & labor practices, employee health & safety, and diversity & inclusion. Common examples within the corporate Governance category are board compensation & structure, executive compensation, and business ethics.

Is there a rating or scoring system to determine how “sustainable” a particular fund is?

Yes. Third party rating providers include MSCI, Sustainalytics (acquired by Morningstar), Just Capital, Arabesque S-Ray, ISS, S&P Global, and more. Most of these services require paid subscriptions if you really want to dive into the weeds and compare several companies side-by-side and their respective product involvements related to animal testing, for example. One of the easiest ways to get a quick 30,000-foot view is to reference the Morningstar Sustainability Rating of a company or a fund. Historically, Morningstar is known for their 5-star rating system, which is focused on financial performance. Their Sustainability Rating system is based on a 5-globe scale instead. A 5-star fund indicates that it has outperformed its peers from a financial return perspective; a 5-globe fund indicates it has outperformed its peers from sustainability perspective when it is scored using ESG criteria. Usually a company or fund will receive a score for E, a score for S, and a score for G, and then a blended overall sustainability score. You also may be able to get some ESG information from your financial advisor.  

How can I research or explore socially responsible funds? 

There are many ways to research Environmental, Social, and corporate Governance funds. You can do it by yourself or have a financial advisor knowledgeable about this space help you out. A common way to start is to set a screen to only include ESG funds. For example, let’s say you are looking to invest in a US Large Cap fund. Many brokerages have screeners that allow you to filter out the funds that do not incorporate ESG. At this point, you might have a list of funds that simply have “ESG” in the name of the fund. Just because a fund has ESG in the title doesn’t mean that the fund has the same criteria that you are looking for. Not all ESG funds are the same! A deeper dive can be more tricky. In the case of a fund, you may want to see how the fund scores in the E, S, and G categories as well as an overall sustainability score (see section above). You can also look at the latest holdings report to see what companies the fund owns. This will help you gauge if the fund owns the companies that you want (or don’t want) to invest in. You can also read through the investment objective and prospectus of a fund to get additional information. A statement might be as simple as “The Fund employs a passive management (or “indexing”) approach, investing primarily in large-capitalization U.S. equity securities that exhibit overall growth style characteristics and that satisfy certain environmental, social and governance (“ESG”) criteria.” The previous statement described was directly from one of Nuveen’s ESG Exchange Traded Funds (ticker: NULG).

What has contributed to the rise in popularity of ESG?

ESG has become more popular due to changing investor preferences, generational differences, and published studies which show that returns do not need to be sacrificed by incorporating it into a portfolio (some studies even show outperformance in bull markets and increased downside protection in bear markets). Investors are demanding more from their investments, not just in financial return, but in their societal impact. Generally younger investors (e.g. Millennials, Gen Z) are applying a more scrutinous lens to their investment portfolios compared to older investors (e.g. Baby Boomers). There are also gender differences: women generally have more interest in ESG than men. Fund companies and money managers are listening. They are incorporating ESG criteria into their investment process not only because investors are asking for it, but also because they believe incorporating ESG into a portfolio can help manage risks.

What is the difference between Sustainability and ESG?

ESG generally falls under the umbrella of sustainable investing. US SIF describes it well: “A key strategy of sustainable and responsible investing is incorporating ESG criteria into investment analysis and portfolio construction across a range of asset classes.” One way to think of it is companies that have high ESG scores are more sustainable, resilient, and therefore (theoretically) will be able to generate superior earnings over time. Of course, superior earnings over time would be reflected by positive portfolio performance.

Can a “big oil” company be included in one of these funds?

Yes. Remember when I mentioned that not all ESG funds are the same? Some funds have a “higher bar” than others. Or some simply have a different approach to inclusion within their fund. For example, one fund, Nuveen’s ESG Large Cap Value ETF (ticker: NULV), includes oilfield services company Baker Hughes and the energy company Valero. It does not include companies like Exxon and Chevron, which are part of the S&P 500 Value Index. Another fund, BlackRock’s iShares ESG Aware MSCI USA ETF (ticker: ESGU), not only includes Baker Hughes and Valero, but in addition it also owns Exxon, Chevron, ConocoPhillips, and Marathon! Why is this the case? For the most part these funds start with the same “basket of goods.” In other words, U.S. publicly traded companies. But their processes are different. Nuveen excludes a wave of companies that do not live up to a set of predetermined ESG criteria, then selects the “best-in-class” ESG leaders in their respective sector, and then applies a carbon emissions/intensity screen. When it is all said and done, NULV has less “big oil” companies in their portfolio. BlackRock applies business involvement screens to their ESG Aware funds. The five screens they outline are civilian firearms, controversial weapons, oil sands, thermal coal, and tobacco (see definitions here). After applying their screens they still include the aforementioned companies in the fund. Again, not all ESG funds are the same.

Mitch DeWitt, CFP®, MBA