A growing number of investors are interested in Environmental, Social and Governance investing, known as ESG. That term is becoming more common, but ESG still means different things to different people.
While some investors are drawn to the socially responsible side of ESG investing — a more emotionally- driven, morals-based approach that aims to create a portfolio that aligns with the investor’s values — others approach ESG factors as a way to evaluate risks and opportunities and create more sustainable portfolios.
I’ve written about understanding your motivations for ESG investing, and this is a good place to get started if you’re unsure about your own. Once you’ve figured out why you’re drawn to ESG and what you hope to get from it, you can more easily evaluate the methods for adopting an ESG investing strategy that best fits your goals.
Because there are a lot of approaches that you can choose from, each with very different objectives. Understanding different ESG implementation methods is the next critical step in determining the best fit for your portfolio.
Here’s a closer look at six different methods for incorporating ESG criteria into your investment strategy — along with their respective advantages and potential downsides — to help you decide what’s right for you:
1. Exclusionary Screening
This is the oldest method and often the first approach that people think of when they hear “ESG,” “sustainable,” or “socially responsible” investing.
Exclusionary screening involves removing companies from your portfolio based on products or business activities that conflict with your values. That might include businesses associated with alcohol, tobacco, gambling, or weapons manufacturing, just to name a few examples.
Pros: Negative screening lets you align your investments with your beliefs and values. For example, if your religion prevents you from investing in certain companies because of the products or services they sell, exclusionary screening can help you eliminate those businesses from your portfolio. This approach allows you to participate in the markets on your own terms, and that’s better than keeping 100% of your money in cash.
Cons: Research suggests that this approach is harmful to your overall returns. It also may leave you less diversified than you otherwise could be by using a different investment strategy. Worst of all, negative screening can exclude companies you actually like overall — perhaps requiring you to reject a company like Amazon because it sells alcohol through its grocery store chain, Whole Foods.
2. Best-in-Class Selection
This approach is an evolution from the original exclusionary model. Rather than excluding companies for their products and activities, funds that use a best-in-class selection method will score all the companies in a representative index on a host of ESG factors. Then, it rewards the leaders on ESG metrics by overweighting those stocks within the index.
Pros: Positive screening lets you align your investments with either your values or sustainability goals by underweighting or avoiding the companies that don’t excel at ESG. Equally important, research shows that positive screening doesn’t necessarily hurt performance or harm diversification.
Cons: The primary drawback to positive screening is limited information. ESG data isn’t standardized and relies on companies to self-report, so ESG data sets used for the security selection process aren’t perfect.
3. ESG Integration
The ESG integration approach examines ESG criteria alongside traditional financial analysis. This method recognizes that issues like climate change, social inequality, and corporate governance can affect a company’s long-term performance — but it doesn’t emphasize specific ESG-related goals. The point of the integration is to use ESG factors to pursue better risk-adjusted returns.
Pros: Examining ESG factors gives investors more information to help assess a company’s risk profile and return potential. Research suggests this may improve risk-adjusted performance over long periods.
Cons: The data used to analyze stocks is limited and non-standardized. Plus, true integration approaches are usually available only in active portfolios, which unfortunately tend to underperform simple indexes in aggregate.
4. Active Ownership or Corporate Engagement
Active owners use ownership rights to directly engage with companies on ESG issues, such as using proxy votes to try to change the behavior or practices of the company. Owning even a single share of a company entitles you to show up at shareholder meetings and raise hell, file complaints with regulatory authorities, and send letters airing your demands.
Pros: When you take an active role, you can make your voice heard. This corporate engagement gives you a chance for a more hands-on role in pushing for change.
Cons: Having true influence through active ownership requires you to own a major stake, which is why some investors pool their resources and do this as a group. Most individuals simply don’t have the time and bandwidth to be active to the degree required to influence significant change within the corporation’s structure or means of doing business. And, even if you do show up to meetings, there’s no guarantee you’ll see results.
5. Thematic Investing
Thematic funds focus on a single ESG-related area, such as clean energy, sustainable forestry, female leadership, or good board governance. These funds then seek to invest in companies that are most actively working to address the chosen issue while avoiding those that are not.
Pros: If you’re passionate about one particular issue, this method allows you to allocate your dollars to companies or projects that are directly related to what you care about most.
Cons: Because these funds are built around a narrowly defined theme, they can lack diversification. They also put non-financial objectives over financial ones, which sometimes result in higher costs and may hurt long-term performance.
6. Impact Investing
This highly targeted approach invests in particular projects designed to achieve specific measurable goals, such as building affordable housing. The focus here is less on generating a financial return and more on using capital to create positive change in the world.
Pros: Because impact investing has clearly defined goals, you can put your money to work directly toward solutions for issues or problems that you feel are most important for the greater good. The financial return potential is a clear step above charitable giving, because you expect to generate some type of return on your investment.
Cons: This method tends to produce below-market rate returns. There’s often a lot of risk involved, too, because you’re dealing with highly concentrated projects.
ESG investing has expanded in recent years to cover different styles that meet a variety of objectives. That’s great news for the range of investors who are interested in ESG, but who may each have many different goals in mind.
Take some time to understand both your motivation for pursuing ESG investing and what you want to achieve by getting involved with these approaches. Then, take a careful look at the different methods for bringing ESG investments into your portfolio.
By understanding your options, you’ll be better positioned to choose the method (or methods) that make the most sense for your overall plan.
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