What Is ESG Investing and How Does It Compare?

ESG investing is a way to build a more ethical portfolio, and it's easier than you think to get started.

Alana BensonSeptember 18, 2020
ESG Investing: What It Is and Why It's Important

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You've likely heard of "voting with your dollars," or using your money to make purchases at businesses you believe in. But choosing your local bookstore over Amazon isn't the only way you can make an impact. There are strategies, such as ESG investing, to put your investment dollars to work in a similar way.

What is ESG investing?

ESG investing refers to a style of sustainable investing that considers both an investment’s long-term financial returns and how well it follows environmental, societal and corporate governance criteria. Here is a breakdown of each ESG pillar:

Environmental: Environmental factors include how a company mitigates its greenhouse gas emissions, whether the products the company creates are sustainable, if it uses natural resources efficiently and how it deals with recycling.

Social: The social component includes factors both inside and outside the company. Does the business participate in community development, such as providing affordable housing or fair lending? Does it carefully consider diversity and equal employment opportunity in its hiring? Does the company prioritize human rights everywhere it does business, including other countries?

Governance: Corporate governance refers to the company’s leadership and board, including whether executive pay is reasonable, if the company’s board of directors is diverse and whether it’s responsive to shareholders.

Why should I care about ESG investing?

Aside from the benefits of aligning your investment dollars with your moral compass, there is evidence that ESG investments deliver similar returns as traditional investments — and potentially carry less risk.

ESG investing and high returns

A 2019 white paper produced by the Morgan Stanley Institute for Sustainable Investing compared the performance of sustainable funds to traditional funds and found that from 2004 to 2018, the total returns of sustainable mutual and exchange-traded funds were similar to those of traditional funds. Other studies have found that ESG investments can outperform conventional ones.

JUST Capital ranks companies based on factors such as whether they pay fair wages or take steps to protect the environment. It created the JUST U.S. Large Cap Diversified Index (JULCD), which includes the top 50% of companies in the Russell 1000 (a large-cap stock index) based on those rankings. Since its inception, the index has returned 15.94% on an annualized basis compared to the Russell 1000’s 14.76% return.

ESG investing and lower risk

The same Morgan Stanley study found that sustainable funds consistently showed a lower downside risk than traditional funds, regardless of asset class. The study found that during turbulent markets, such as in 2008, 2009, 2015 and 2018, traditional funds had significantly larger downside deviation than sustainable funds, meaning traditional funds had a higher potential for loss.

ESG vs. SRI: 2 ethical investing approaches

Another common term for the process of creating an ethical investment portfolio is socially responsible investing, or SRI. While SRI and ESG both seek to build more responsible portfolios, there are two main differences between ESG investing and SRI investing:

  1. Exclusion vs. inclusion. SRI has historically used an exclusionary approach to filter out certain investments, such as stocks in industries some people consider against their values, like tobacco or alcohol (these are also known as sin stocks). ESG investing can both exclude those same investments and include companies deemed to be creating a positive impact in the environmental, social or governance areas.

  2. Factoring in performance. Critics have argued that because SRI only looks to exclude companies that aren’t “morally good,” it limits an investor’s ability to build a strong portfolio. ESG investors believe that companies with, for example, a diverse team, limited negative environmental impact and reasonable executive pay are more likely to be in business longer and deliver better long-term financial returns. Essentially, companies that are “morally good” aren’t just good for your conscience, but also for your portfolio.

Easy ways to get started with ESG investing

Deciding which companies fit within your vision of ESG investing is a lot of work. Investing with ESG funds or through a robo-advisor can make it faster and easier to start an ethical investment portfolio.

ESG funds

If you’re looking for a quick way to become an ESG investor, one place to look is ESG mutual funds, rather than researching individual stocks. ESG funds hold companies that fall in line with ESG values and exclude companies that do not. Some funds are specifically focused around one issue, such as advancing women in leadership or promoting environmental stewardship. You can research funds through the Forum for Sustainable and Responsible Investment or with an online broker's mutual fund screening tools. With an online brokerage account, you can also purchase specific funds. (Here are our picks for the best brokers for mutual funds.)

One thing to be aware of when investing in ESG funds is that a “sustainable” fund may look similar to a regular fund, or it may hold companies you wouldn’t personally consider sustainable. For example, Fidelity's non-ESG Disciplined Equity Fund and its U.S. Sustainability Index Fund (which incorporates ESG factors) are both classified as large-cap blend funds and have significant overlap in their top 10 holdings. Both include Microsoft, Alphabet, Visa, Mastercard and Nvidia.

Seeing so much overlap may feel discouraging, but remember that weighing the social responsibility of a business can get pretty muddy. For example, what happens when you have a company run by women that makes bombs in an environmentally conscious way? Funds are the easy way to have your portfolio cater to what you care about, but if you want total control of the companies you invest in, you’ll need to research the individual stocks yourself.

» Excited about ESG? Learn how to invest in mutual funds

Robo-advisors

Robo-advisors use computer algorithms to build and manage an investment portfolio for you, and some offer an alternative portfolio that is geared toward ESG or socially responsible investments. Here are some of our top picks for robo-advisors that offer an ethical investing option.

SoFi Automated Investing
NerdWallet rating 

on SoFi Invest's website

Fees and minimums:

  • $0 per year.

  • $0 account minimum.

Ethical investing options:

  • SoFi will build a portfolio around an impact area chosen by the investor, such as environmental conservation or gender equality.

Betterment
NerdWallet rating 

on Betterment's website

Fees and minimums:

  • 0.25% per year.

  • $0 account minimum.

Ethical investing options:

  • Investors can opt into an SRI portfolio.

Ellevest
NerdWallet rating 

on Ellevest's website

Fees and minimums:

  • $1 - $9 per month.

  • $0 account minimum.

Ethical investing options:

  • Impact Portfolios invest in companies that advance women and meet high ethical standards.

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