Breaking Down Socially Responsible Investing
Many investors want more out of their investments than just a good return. They want to know
that the companies they invest in are ethical and responsible — that they build environmentally
sustainable business models, advance a social good and operate in a transparent, ethical way. To
identify these companies, socially responsible investors can use a set of criteria known as ESG.
ESG basics
ESG is short for environmental, social and governance. Investors can use each element of this
framework to screen their investments and build a socially responsible portfolio. Here’s a closer
look:
- Environmental issues include emissions and pollution, climate change, water
conservation and renewable energy. Corporations demonstrate environmental
responsibility by setting goals to decrease their negative impact on the environment and
by showing progress. - Social issues include diversity and inclusion, poverty, worker exploitation and human
rights. Corporations demonstrate social responsibility by recruiting a diverse workforce,
maintaining a safe work environment, compensating fairly, protecting the communities
they operate in and holding the companies they do business with to similar standards. - Governance issues revolve around the internal workings of the corporation. Some, such
as employee treatment and compensation and diversity among corporate leadership,
overlap with social issues. But governance is broader than that. ESG investors favor
companies that communicate transparently with shareholders, divide power among
different positions with different perspectives, and guard against nepotism and
corruption.
The ESG framework gained popularity in the 2000s with the rise of socially responsible
investing. It was largely fueled by two reinforcing factors: Investors were becoming increasingly
interested in the social and environmental impacts of their portfolio companies, and the long-held
notion that corporate responsibility hurt profits was overtaken by the theory that responsible
practices actually improve a company’s long-term prospects and reduce risk. Consider that 57 of
Morningstar’s 65 ESG-screened market indices have outperformed their ESG-indifferent
counterparts over the past five years.
What gives companies that meet ESG criteria a competitive edge? It may be that businesses that
rely on sustainable sources of energy and materials are naturally more fit for long-term survival.
Those that treat their workforce well may improve employee productivity, decrease turnover and
avoid bad press and lawsuits. And companies with good governance practices may ensure
competent leadership, avoid scandal and increase shareholder returns by reducing executive
salaries and bonuses.
Building a responsible portfolio with ESG funds
You may not feel you have the time or expertise to independently evaluate the ESG performance
of every stock you might want in your investment portfolio. Many ESG investors rely on ESGfocused
index funds, mutual funds and exchange-traded funds to build a balanced, diversified,
socially responsible portfolio.
An ESG fund may still hold stock in companies you don’t agree with for moral or ethical
reasons, such as distilleries, weapons manufacturers or casinos. These companies may perform
well on an ESG evaluation, so if you have qualms with certain industries, be sure to seek out an
ESG fund that specifically excludes them.
There is no universal ESG standard, so it’s important to read the prospectus of the fund you’re
considering to understand what criteria a fund is using. Commonly found on a fund’s website,
the prospectus gives detailed information about how the fund operates, detailing its objectives,
risks, fees and expenses. The Securities and Exchange Commission also maintains a searchable
database of fund prospectuses. You may also consult a financial advisor to help you determine
which ESG funds meet your objectives and are appropriate for your portfolio.
Sources:
https://www.morningstar.com/insights/2021/02/08/morningstars-esg-indexes-haveoutperformed-
and-protected-on-the-downside
https://www.sec.gov/edgar/searchedgar/prospectus.htm
Environmental Finance. (2004). United Kingdom: Fulton Pub. Limited.
https://www.reuters.com/article/us-usa-guns-blackrock/investors-embrace-esg-investing-butdont-
target-gun-stocks-idUSKCN1UZ22J
https://www.ussif.org/article_content.asp?edition=1§ion=3&article=19