Personal Investing

Getting started on responsible investing: What you need to know

8 Minute Read

The focus on environmental, social and governance (ESG) issues has taken the business world by storm, and individual investors are taking notice.

In a recent survey of investors with an average of $1.6 million in investable assets, nearly three-quarters said they were open to learning more about responsible investing, and over one-third wanted their investments to be aligned with their personal values.

If you are an investor looking to make ESG a factor in the construction of your portfolio, here are some key considerations:

1. The first step is defining the type of responsible investor you want to be.

Defining terms here is critical. Labels like “socially responsible investing” and “sustainable investing” can mean different things to different people. As a result, before you initiate a new investment approach, you want to be very clear about your goals.

Investment experts point to a variety of approaches to responsible investing, most of which fall into two broad categories. Start by figuring out which of these best represents your goals:

Social impact investing. Simply put, this is investing in areas of the market with the intention of making an impact on society that aligns with your values. For instance, if you want to address climate change or promote social justice, you would look to invest in companies that are seeking to directly impact those areas.

For a social impact investor, effecting change in the environment, society and/or corporate governance tends to supersede more traditional goals around investment returns.

ESG integration. ESG encompasses everything from climate risk and alternative energy (environmental), to pay equity and good corporate citizenship (social), to cybersecurity and diversity initiatives (governance). An ESG integration approach to investing focuses on how well a company is addressing risks and contingent liabilities related to these issues. As such, it’s less about social impact and more about evaluating how adherence to ESG standards will affect a potential investment target’s financial performance and risk-adjusted returns over the long term.

In other words, ESG integration is about gauging mindfulness around environmental, social and governance issues and making that a high priority in the investment evaluation process — along with other traditional criteria such as business model, profitability, and growth potential.

2. How you define “responsible investing” will likely impact your portfolio’s performance.

The data is mixed, but there is some evidence that responsible investment efforts can lead to higher returns. For example, ESG funds have outperformed non-ESG funds globally since 2010,  and in Europe, an early adopter of ESG principles, the market has been punishing companies that have failed to be ESG mindful. Yet there is no guarantee that such trends will hold up over time.

What does appear certain, however, is that social impact  investing can constrain investment performance. There’s an inherent tradeoff. If you take a narrow approach to investing, such as a strict focus on climate or social justice, your social impact capital will support companies aligned with your values. But at the same time you will forego the diversification that traditionally leads to better returns over time. As an investor, you have to ask yourself: Am I comfortable with that?
 
3. The options for responsible investing are extensive and growing.

ESG has made its presence known in the investment arena, evidenced by the growing number of ESG-friendly investment alternatives and high levels of adoption.

US SIF: The Forum for Sustainable and Responsible Investment reported in late 2020 that the actively managed U.S. ESG market has nearly tripled over the last five years. Meanwhile, the proliferation of ESG investment products has been especially notable in the rapidly growing ETF (exchange-traded funds) market. ESG ETF assets increased $55 billion in the first quarter of 2021, and as of June 2021 had experienced 50 consecutive weeks of net inflows.

ESG is driving funds flows. ESG funds have seen $318 billion in inflows since 2020, while non-ESG active equity funds have lost $446 billion in that time.

4. Because the landscape of responsible investing is so complicated, it’s wise to seek professional investment counsel.

So much is going on in the ESG investing space and there are so many angles to consider that, rather than picking investments on your own, it will pay off to work with an investment advisor on developing a responsible investing strategy. Just a few of the developments that advisors can help you manage include:

  • A growing number of ESG research firms as well as more traditional credit rating agencies are ESG-scoring companies, but no one uses the exact same standards.
  • The number of indexes that now benchmark ESG investment performance has risen above 1,000.
  • Standards continue to evolve for corporate ESG reporting.

It’s best to lean on investment professionals who closely follow these developments and have the technology resources to navigate you through the ESG investing maze. Investment pros have screening tools that enable them to construct a portfolio to your specifications. For instance, they can screen to include only those investments that adhere to Shariah law or exclude funds with companies that engage in animal testing.

ESG is becoming a mainstream investment consideration and, as an individual investor, you need to establish how you will make it a part of your investment process.  Start by clarifying your investment goals around ESG and understanding the tradeoffs involved in whatever approach you adopt. An investment advisor can walk you through the initial steps and then help you execute a responsible investing strategy.

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