4 Myths of ESG Investing — How to Put Your Money Where Your Morals Are
Updated: May 4, 2022
Over the last several years, ESG investing has become more popular among institutional and individual investors alike. As a result, ESG — environment, social, and governance — factors now play a role in how many money managers and wealth advisors filter investment selections. Environmental issues, like climate change, carbon emissions, and water and air pollution are the most significant driving force behind ESG investing. However, social concerns, like human rights, gender pay equity, diversity and inclusion, and data privacy are becoming more of a focus. Governance concerns, including bribery and fraud, transparency of political contributions and lobbying, and board diversity also make up prominent ESG factors.
Taking these specific issues that revolve around environmental concerns, social initiatives, and governance mandates into account, investors big and small may have a more significant impact on their community and the world at large. This idea appeals to investors worldwide, and the most recent statistics point to that reality.
According to the latest trends report by US SIF on Sustainable and Impact Investing, of the $51.4 trillion managed assets within the United States at the end of 2019, $17.1 trillion included some form of ESG incorporation. Compared to 2018 data, ESG incorporation in investments rose 42% year over year, and now represents one in every three dollars across individual and institutional investors.
While the rapid rise in ESG investing shows a clear trend toward growth in the space, the term ESG and how its factors are incorporated into investment strategies have sparked confusion and misunderstanding among investors. To help investors curious about socially responsible and sustainable investing through ESG incorporation, it’s necessary and helpful to break down some of the most common myths surrounding ESG investing.
Myth #1 — Investors Give Up Performance with Socially Responsible Investing
One of the most prevalent myths about investing with environmental, social, and governance factors in mind is that ESG investments don’t perform as well as others. The common worry here is that investing in companies that “do good” by reducing their impact on environmental conditions, promoting social initiatives like gender equality and living wages, or increasing board diversity and curtailing executive compensation, ultimately generate less profitable returns for shareholders and investors. In addition, some skeptics cite the increased cost of doing business with an ESG focus leads to lagging returns.
The reality is that investments that screen for certain ESG factors often perform just as well as those without ESG incorporation. For example, recent reports suggest that equity ESG funds outperformed their non-ESG counterparts by a median total return of 4.3% in 2020. Experts suggest that the difference between ESG and non-ESG fund performance is linked to a lower cost of doing business, minimized volatility, and fewer occurrences of corruption. Some also tout that ESG incorporation in investment selection allows for less downside risk over the long term.
Although all investments come with some degree of risk and past performance does not indicate future returns, ESG incorporation does not necessarily lead to underperformance compared to non-ESG investments.
Myth #2 — ESG Investments are Just a Fad
Some believe that ESG investing is a passing trend, despite the substantial inflows of money into social and sustainable investments over the last few years. Others argue that because ESG investing lacks a consistent framework and process, greenwashing — the opportunistic use of the term ESG without any of the tenets of ESG incorporation or screening — runs rampant. Finally, some also believe there is no true and measurable impact of ESG investing, and therefore, growth in the space can’t and won’t continue.
While issues like greenwashing and flimsy guidelines for ESG definitions are real, investing in a way that is aligned with one’s values and ideals is not a fad. Instead, investors are increasingly interested in how their dollars are being used, which leads to holding companies accountable for their business practices within environmental, social, and governance arenas. Additionally, as definitions of ESG investing become clearer and measuring the impact of ESG initiatives becomes more commonplace, more investors are likely to join the ranks.
ESG is still a relatively new concept to many investors. However, the growth of ESG-focused investments and money flow into the space shows it is not a short-lived trend.
Myth #3 — Diversification Doesn’t Exist in ESG
Another common misconception is that investing with ESG in mind means giving up the diversification of an investment portfolio or fund. The thought process behind this myth is that focusing on environmental, social, or governance factors in selecting investments ultimately eliminates entire sectors, such as the oil and gas industry or “sin stock” companies like those producing tobacco or weapons. Although some ESG funds operate on an exclusionary basis, eliminating industries and sectors in one broad stroke, not all ESG investments function similarly.
Many ESG investments have incorporated an integration approach instead of an exclusionary one in recent years. This means that instead of eliminating all sectors at the start of the investment selection process, money managers are opting to evaluate industry-specific criteria to identify the companies excelling in ESG initiatives, and those that are lagging. The inclusion of the best-in-class options across various industries allows for greater diversification than the exclusionary process in ESG.
There is some degree of reduced diversification in ESG investing, but that does not lead to an undiversified portfolio or the elimination of entire sectors. Investors should do their due diligence to understand how their ESG investments screen for various factors and if they are utilizing exclusionary or inclusionary methods in the process.
Myth #4 — All ESG Investments are Created Equal
Some investors feel that an ESG fund or portfolio from one money manager is the same as the next — that anything investment with an ESG or “green” sticker slapped on it focuses on the same aspects of social and sustainable investing. It begs the question, how could there possibly be that much differentiation between investment options in the ESG space?
The reality is that not all ESG investments are created equal. The unfortunate truth is that plenty of greenwashing exists in the ESG investing arena. A handful of fund managers simply add a few filtering screens to their current portfolios and say they are now incorporating ESG into the mix. However, there are also many more focused on doing the actual work that ESG entails. Choosing environmentally, socially, and governance-oriented investments involves building out processes and screening criteria based on specific ESG factors, applying those methods consistently, and measuring the impact of those practices over time.
Additionally, money managers and wealth advisors working in ESG focus their attention on shareholder advocacy to keep companies accountable. Finally, investors can easily see the proof of ESG integration among those doing the work.
Readily available, transparent information about the ESG process, its impact, and ongoing data allow investors to conduct their due diligence on an ESG investment.
The Bottom Line
ESG investing encompasses different things for different investors. For some, it may mean focusing on investing in companies with a low carbon footprint or actively reducing air and water pollution. For others, it may involve putting their investment dollars to work with companies dedicated to pay equality, diversity and inclusion, human rights, or transparency in political contributions. No matter the drive for ESG investing, investors big and small should know that their money can work toward the greater good.
To do so with full confidence requires breaking down the prevalent myths surrounding ESG investing. As the market for ESG investing grows, so does the data available about past performance, diversification within ESG funds, and how to spot a true ESG investment. These components help drive more understanding and greater transparency in the ESG space
If you have questions about ESG investing, feel free to reach out! We are happy to discuss how we incorporate ESG factors into clients’ investment strategies. If you’re unsure if ESG investing is right for you, take our brief quiz. The results will shine a light on what’s important to you — and that is important to us.