What is ESG Investing? And Why It's More Important Than Ever Before

4.0 MIN READ

Every year, Larry Fink, the CEO of BlackRock, pens a letter to chief executives of the world’s largest companies.  This letter is viewed with extreme importance because BlackRock is the world’s largest asset manager, overseeing nearly $7 trillion in investments.  These investments hold corporate stock and debt meaning BlackRock has a stake in many of the world’s largest companies.  Fink has a fundamental say in how finances are managed both now and in the future.  

The main focus of Fink’s 2020 annual letter is sustainable investing.  He states that BlackRock will stop investing in companies that present a “high sustainability risk” such as coal producers.  Fink also states, “Over the 40 years of my career in finance, I have witnessed a number of financial crises and challenges – the inflation spikes of the 1970s and early 1980s, the Asian currency crisis in 1997, the dot-com bubble, and the global financial crisis. Even when these episodes lasted for many years, they were all, in the broad scheme of things, short-term in nature. Climate change is different. Even if only a fraction of the projected impacts is realized, this is a much more structural, long-term crisis. Companies, investors, and governments must prepare for a significant reallocation of capital.”

The reallocation of capital is becoming increasingly relevant in our society today, especially given the social movements of climate change, racial equality, gender equality and more.  Capital is shifting from baby boomers to millennials today and the trend is only expected to continue at an estimated $68 trillion over the next 30 years.  This event is known as “The Great Wealth Transfer”, the largest transfer of money in modern history.  The next generation will not only inherit wealth, it will also inherit positions of power.  As Fink states in his annual letter, “And as trillions of dollars shift to millennials over the next few decades, as they become CEOs and CIOs, as they become the policymakers and heads of state, they will further reshape the world’s approach to sustainability.”

Environmental, Social, and Governance (ESG) funds reported record inflows of $45.7 billion in the first quarter of 2020.  It’s safe to say that the trend has already started.  The recent pandemic and social outcries for equality will likely only enhance the inflows.  Investors are shifting from the traditional school of thought that a company’s number one priority is to maximize shareholder wealth.  This was how finance was taught to me in university and in my professional life.  But times are changing.  There is a rising movement for companies to increase “stakeholder” investment or those that have an interest in the company directly or indirectly such as employees, customers, or communities.  

ESG investing is more relevant than ever before and here is what you need to know about it.

Definition of Environmental, Social and Governance (ESG) Investing

ESG investing incorporates additional screening outside of traditional fundamental analysis of a company.  The determinant of ESG investing is dependent on how the investor rates the company as socially conscious in the categories of Environmental, Social, and Governance.

Definition of Environmental (The “E”)

The environmental component of ESG focuses on the conservation of the natural world.  Companies that screen positively on metrics such as carbon emissions and efforts to combat climate change will fit in this category.  Other areas of interest within the environmental component include companies that focus on reducing air pollution, deforestation, water scarcity, and waste management.

Definition of Social (The “S”)

The social component of ESG considers the relationship between the company and people.  People include employees, customers, and community members.  Criteria for screening the social aspect include customer satisfaction, data protection, gender, diversity, community relations, human rights and labor standards.

Definition of Governance (The “G”)

Governance refers to the standard in which the company is run.  This includes board composition, bribery and corruption review, lobbying, political contributions, and executive compensation.

The Argument for Environmental, Social and Governance Investing

Performance results are a major concern when it comes to investing in ESG funds.  However, it shouldn’t be according to a study completed by Morningstar in 2019.  The study concludes that 41 of 56 unique Morningstar ESG indexes outperformed their non-ESG equivalent which is a 73% success rate.  ESG screened funds used in the study exhibited that environmental stewardship helps companies control costs and be well positioned for the future of our planet.  Treating employees and customers well also led to an increase in retention, which reduces turnover cost.  ESG funds will continue to challenge non-ESG funds in performance, especially as inflows continue to rise over time.

The Challenge with Environmental, Social, and Governance Investing

ESG investing is becoming increasingly popular and has made its way into the mainstream.  As more investment firms are aware of this trend, they may develop funds that may not fully constitute ESG investments but rather use it as a marketing platform.  Thus, it becomes even more critical to screen properly.  Luckily for investors, regulators such as the Securities and Exchange Commission (SEC) are beginning to scrutinize ESG portfolios and screening mechanisms.  Oversight will make sure investors are protected.  As stated in this Investment News article, we at Fyooz Financial Planning believe additional scrutiny is needed and we welcome it.

Interested in screening a company or fund for ESG ratings? Check out this resource!

How Do I Know If I Should Invest in Environmental, Social and Governance Funds?

As said before, hypothetical performance results inhibit potential investors from buying shares in ESG related funds.  The problem with this concept is that any investor interested in ESG should really be focused on personal satisfaction of investing with your values rather than focusing on overall investment performance.  An ESG investor should be satisfied giving up a percentage point in return (even though the Morningstar study says otherwise) by knowing dollars are going where the investor believes a difference is being made.  As soon as an investor sets a rate of return investment goal, he, she or they are immediately setting themselves up for disappointment.  This puts immediate strain on an investor and may lead to a tendency of market timing.  Instead, the focus needs to be on achieving a life worth living, knowing your dollars are going to a cause or company you believe in.

About the Author
Daniel Slagle, CFP is a founding partner of Fyooz Financial Planning with his wife Natalie, CFP. Together, they seek to help couples and young families use money as a tool to become closer together.

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