Interest in sustainable investing, also known as responsible investing, has exploded in recent years. The continued integration of responsibility criteria into investment processes has been one of, if not the most important, trends of the past year. In fact, according to a recent study, over 75% of investors globally are incorporating ESG into their investment strategies, while US sustainable funds are seeing net inflows of $15.7 billion.
Many companies with good ESG track records demonstrated lower volatility than their non-ESG rivals during the market upheaval caused by the COVID-19 pandemic. That outcome, for many investors, justified ESG investment and the principle that underpins it: that a good track record of corporate behavior leads to greater financial results. But, what exactly is ESG, and how does it relate to ETF investing?
- The 3 pillars of ESG
- What is an ESG ETF?
- Benefits of ESG ETFs
- Risks of ESG investing?
- The bottom line
The 3 pillars of ESG
ESG stands for Environmental, Social, and (corporate) Governance. These are the three criteria used to assess a company’s sustainability management and adherence.
The Environmental element looks at how a firm affects the environment – everything from its climate change policies, emissions, and carbon footprint, to water and energy usage, to employee incentives such as encouragement of public transport, bicycle commuting, and recycling.
The Social element covers all factors affecting people – everyone from employees and customers, to suppliers, to the surrounding community. This can include employee salary, treatment, training and retention, as well as safety practices, supply chain management, customer service, and social justice issues in the local community.
Finally, the Governance element covers leadership, the board of the company, and business ethics as a whole. Subtopics might include diversity in leadership roles, enforcement of ethical practices through policies, transparency in communication with shareholders, relationships with regulatory bodies, and history of lawsuits.
Growing research suggests that organizations that perform well under this criterion – in other words, organizations with high non-financial quality indicators – appear to outperform on market-based criteria and can produce equal or superior financial results to their non-ESG counterparts.
It’s not clear why ESG companies do well. According to one idea, a company’s ESG strategy necessitates exceptional leadership. ESG efforts are long-term projects, and a leadership team’s ability to achieve long-term goals while keeping the core business functioning smoothly is a competitive advantage.
What is an ESG ETF?
ETFs that invest in environmental, social, and governance (ESG) issues use a combination of two investment strategies:
- The responsible investment strategy: As mentioned above, this refers to a variety of approaches incorporating environmental, social, and governance (ESG) considerations into the investment process.
- The ETF investment strategy: ETFs are pooled investment vehicles that invest in a diversified portfolio of stocks, bonds, and other assets. ETFs are often linked to a certain index and provide a cost-effective and flexible approach to establishing a well-diversified investment portfolio.
Simply put, ESG ETFs provide an easy approach to diversify across a broad range of investments while owning companies with excellent environmental, social, and governance attributes.
Benefits of ESG ETFs
Investing in your values
ESG ETFs can make ethical investing simple when building your ideal portfolio, and make it easy for you to invest in line with your values and principles. For example, ESG focused ETFs specific can target companies with excellent ESG ratings or even more specific issues, such as gender equality or fossil-free energy, while certain contentious sectors, such as tobacco or guns, are bypassed.
ESG ETFs can help you diversify your portfolio. ESG ETFs are available across a variety of asset classes, industries, and regions. These funds also provide a variety of options for incorporating responsible investing concepts into your portfolio. As a result, ESG ETFs can be used to offer a variety of levels of diversification to your portfolio.
Companies with higher ESG scores are also an indication of quality overall performance. For example, the MSCI Canada ESG Leaders Index, which is an index that gives exposure to firms with strong ESG ratings, returned 11.25% in 2020, compared to 6.21% for the MSCI Canada index.
A smart long-term decision
The interests of the financial world and ‘social good’ will no doubt converge at some time in the future. On a globe rendered uninhabitable by climate change, there are no investment returns at all, so investing with this in mind will make you somewhat future-proof.
Many ESG ETFs are available for a modest price. As a result, they are a low-cost option for long-term assets in the core of your portfolio.
Risks of ESG investing?
As with every investment, ESG ETFs do have some associated risks. Here are a few you might wish to consider before investing.
There are currently no universally accepted standards for assessing ESG performance, other than the voluntary Global ESG Disclosure Standards for Investment Products. As a result, different ESG portfolios and funds might have conflicting assets. Some ESG funds, for example, might hold tobacco stocks, which often surprises people.
You want to double-check that your ESG funds are in line with your personal ideals. Learn how the fund screens its investments before investing in ESG ETFs.
There are many examples of funds that have been rebranded as “green” without any visible changes to the fund or its strategies. This is known as greenwashing, and such claims are becoming more common. Interestingly, over 80% of ESG ETFs today still have some exposure to fossil fuel production.
Insufficient long-term data
The Financial Times notes that while many studies show that ESG investing is starting to outperform its non-ESG competitors, the evidence that it outperforms over the long term is inconclusive. They go on to emphasize that there is no logical or factual basis to believe that the “ESG factor” results in better relative performance, or that it will remain a permanent element of the market.
While this doesn’t imply that investors should not invest in causes that are important to them, it simply indicates that they should not consider this as their only wealth-maximizing strategy. Market trends are fluid and change all the time – putting all your eggs into the ‘sustainability basket’ may not give you the returns you hope for.
The bottom line
ESG provides a framework for companies to analyze modern-day business risks and opportunities (in other words, improved investment returns).
Investing with ESG ETFs could be ideal for you if you want to achieve returns while supporting companies that use sustainable, future-oriented business practices. Ultimately, ESG ETFs are about more than personal values. They provide an opportunity to put together cost-efficient, diversified portfolios of high-quality companies.
You just have to be proactive with your background research. Make sure to examine the fund documents carefully, and check if existing fund strategies have been rebranded as ESG.
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