ESG Investing: A Beginner’s Guide

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?

Environmental, social and governance, or ESG investing, is a form of sustainable investing that considers an investment’s financial returns and its overall impact. An investment’s ESG score measures the sustainability of an investment in three specific categories: environmental, social and corporate governance.

What is ESG? Environmental, social and governance criteria

To understand how ESG investing works, you have to understand what each ESG factor measures. Each pillar of ESG, environmental, social and governance, showcases different areas where investments can be scored. Here are the three ESG factors and what they each entail:

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: Governance (or 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 creating a more ethical portfolio, 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 with 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 with the Russell 1000’s 14.76% return.

» Excited about ESG? Check out these ESG-based portfolios

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 funds have even managed to post strong performance during 2020. Of 26 sustainable index funds analyzed by investment research company Morningstar in April, 24 outperformed comparable traditional funds in the first quarter of 2020 (and the beginning of the COVID-19 pandemic). (Morningstar is a NerdWallet advertising partner.)

ESG vs. socially responsible investing

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

ESG is a system for how to measure the sustainability of an investment in three specific categories: environmental, social and governance. Socially responsible investing, ethical investing, sustainable investing and impact investing are more general terms. Often, “socially responsible investments” are judged using an ESG-based grading system.

Historically, certain forms of sustainable investing varied in how they created their portfolios. For example, SRI used an exclusionary-only approach to filter out investments some considered immoral, like tobacco or alcohol. ESG investing excluded those same investments, but also included companies deemed to be creating a positive impact.

The larger the world of sustainable investing has grown, the more those terms (among others) have been used interchangeably. You’ll see providers who offer a “socially responsible” portfolio that includes ESG funds (as opposed to just excluding certain investments), and ones with the same title that use a solely exclusionary approach. That is why it’s important to look into the methodology used to create a portfolio — no matter what it’s called.

ESG investing: How to get started

Starting a portfolio and filling it with environmentally, socially and governance-minded investments doesn’t need to be difficult. And since there are more ESG investments than ever, you’ll have lots of options to choose from. Here’s how to build an ESG portfolio.

1. Choose to DIY or get some help

If you want to create an ESG-style investment portfolio, you’ll have to decide whether you want to do it yourself by picking specific ESG investments or find a robo-advisor that will do the work for you.

I want to find my own ESG investments. If you like the idea of reading up on a company’s sustainability initiatives or ensuring a fund’s companies are in alignment with your moral compass, you may want to build your own ESG portfolio. If you need a brokerage account, here's how to open one. Keep in mind, some brokerages have screening tools that can help you sift through various ESG (or sustainable/socially responsible/ethical) investments. Once you have a brokerage account, you can head to the next step.

This is a lot to keep track of. Help me! Building an investment portfolio takes time, especially when you are trying to find investments that align with a particular framework, such as ESG. Robo-advisors can make this easier. Robo-advisors are digital advisors that build and manage investment portfolios based on your risk tolerance and goals. They’re usually much less expensive than in-person advisors. And now more than ever, robo-advisors are jumping on the ESG bandwagon — often letting investors opt into a sustainable portfolio for no extra charge.

Just remember to investigate a potential robo-advisor’s methodology to make sure they use both inclusionary and exclusionary filters if you decide that’s important to you. If you choose to work with a robo-advisor, you won’t need to follow the rest of the steps.

» ESG for no extra fee? Explore robo-advisors with socially responsible portfolios

2. Know your own ESG policies

ESG has some pretty clear boundaries, especially in comparison to “ethical investing” or “socially responsible investing,” but that doesn’t mean it fits perfectly with your beliefs. Values differ from person to person, so take a little time to identify some of the values most important to you, and see if any fall outside of what “ESG” entails. If they do, make sure you’re looking for investments that also incorporate those ideals. For example, Muslim investors may want to ensure that their investments comply with Islamic law.

3. Find your ESG investments

Once you have a brokerage account and you know what industries you want to support with your investment dollars, you can start creating your portfolio.

Reading reviews from independent research firms such as Morningstar can show you how a company or fund scores in terms of ESG investing factors, and whether you’d like to invest in them.

» Research ESG investments. Learn about Morningstar Premium

When you’re creating your own ESG portfolio, you’ll likely include the following two kinds of investments.

Individual stocks. It’s usually a good idea to limit the portion of your portfolio that’s in individual stocks, but if you really like a particular company (and you think it will perform well over time) you may want to buy its stock. Some companies offer an impact report, which will highlight any sustainable or cultural initiatives they’ve implemented and how they handle issues such as carbon emissions. If you want to know how a company scores in terms of its work environment, check out a third-party site such as Glassdoor. You’ll also want to look at more typical factors such as revenue and net income. Learn more about how to research stocks.

Mutual funds. Funds can fill out your portfolio quickly, and can diversify your holdings instantly. The number of ESG funds has surged in recent years. According to Morningstar data, there were 303 open-end and exchange-traded funds in 2019, up from 270 in 2018. Some of these funds focus on a particular issue, such as green energy, making it easy to personalize your portfolio’s area of impact. If your broker offers a mutual fund screening tool, you can compare different funds to see how their ESG ratings stack up.

To learn about the specific details of a particular fund, such as what companies the fund invests in, you’ll want to look through its prospectus. This document should be available on your online broker’s website, and will include other helpful information like the fund’s expense ratio. Expense ratios are annual fees taken as a percentage of an investment. To figure out how much you’d pay to own a specific fund, you can use a mutual fund calculator.

What's the easiest way to invest responsibly?

Using a robo-advisor that offers a socially responsible portfolio (which are typically built from ESG-graded exchange-traded funds) is the easiest way to get started with sustainable investing. Of the robo-advisors that NerdWallet reviews, the following currently offer socially responsible portfolios or access to ESG investments and earn a star rating of 4.5 or higher.

* These robo-advisors are NerdWallet advertising partners.