ESG: Pros and Cons of Values-Based Portfolios

Key Takeaways:

• ESG—environment, social and governance—investments have seen strong inflows in recent years.
• ESG investors cite aligning their values with their wealth—and return potential—as big reasons to use this investment approach.
• Greenwashing and a lack of universal standards can make ESG investing challenging.

In recent years, a growing number of people have become aware of new and evolving thinking around environmental sustainability, workplace diversity, ethical decision-making practices, discrimination and similar issues impacting both life and business throughout the country.

Investors are increasingly reflecting that awareness in terms of the types of stocks and other securities they buy—and avoid. Investment portfolios that are guided in part or entirely by concerns about companies’ workplace policies and broader societal impact are becoming popular, particularly among high-net-worth individuals and families.

Consider some recent trends:

• According to Morningstar, $3.1 billion flowed into ESG funds—which invest in companies with strong environmental, social and corporate governance efforts—and nearly 90 ESG funds were established in 2022.
• The majority of wealthy investors (55 percent) say investing in causes with a positive ESG impact is a critical wealth management objective, according to Capgemini.
• Twenty-two percent of institutional investors use ESG considerations in at least 75 percent of their portfolios, according to BNP Paribas. Forty-seven percent of institutional investors predict that ESG will be central or necessary to their work in two years.
• Seventy-eight percent of ultra-high-net-worth investors—and 81 percent of high-net-worth investors under age 40—are likely to request ESG scores from their advisors, according to Capgemini.

Given the growing prominence of socially responsible investments—particularly among the affluent—an obvious question is: Should you add these investments to your own portfolio? To help you decide, consider some key pros and cons of ESG investing.

Know the landscape

First, it’s important to get a good handle on just what socially and environmentally focused investing entails. The fact is, many investors aren’t quite sure what it really means. Example: According to Spectrem, fewer than half of investors are familiar with most types of social investing, and only 43 percent of investors can accurately define ESG investing.

Broadly, then, ESG investing is designed to identify businesses that operate responsibly and effectively in (as noted) the areas of environment, social and governance. The goal is to allocate capital to those companies that meet or exceed certain standards in those three areas—or that are working hard to meet such standards—while avoiding firms that don’t.

Diving deeper, that focus often looks like this:

1. Environment. Climate change developments and threats are driving more companies to take actions to limit their environmental impact and mitigate climate risks that could hurt their financial health. Firms taking steps to reduce their “footprint” on the Earth are often prime candidates for ESG portfolios.
    
2. Social. This reflects companies’ approach to a broad range of issues, both internal—employee hiring and compensation practices, workplace diversity and inclusion, employee development—and external (how the business works with its local community and government as well as with other businesses and customers to create overall social benefits).
    
3. Corporate governance. This is all about the practices, processes and controls that companies’ management and/or board implement to make their decisions and oversee themselves. Governance is a broad category that can reflect a company’s ethics, how it meets certain regulations, how it treats stakeholders in the business, the level of diversity among its leadership and a host of other concerns.

How might all this translate to an investment portfolio? An ESG-focused investor might, for example, emphasize shares of businesses that focus on mitigating ocean waste or firms with a higher-than-average percentage of women in C-level roles. That investor might also avoid shares of companies that he or she believes erode important social or environmental conditions. Such companies could include tobacco manufacturers, gambling operations and predatory lenders.

What’s driving ESG interest?

Money is pouring into ESG investments for numerous reasons. Chief among them:

1. Alignment of wealth with values. Some investors want their assets to reflect social and environmental causes and other factors that are most important to them, while looking to build their wealth in ways that don’t conflict with their values. Seeking out investments in businesses that engage in (for example) fair trade sourcing of raw materials, racial and gender equity initiatives, or improving the condition of land and water can enable such investors to, in essence, put their money where their mouth is. Consider that, according to Capgemini, the top motivation for 26 percent of high-net-worth individuals who invest in ESG is “to give back to society.” Their top areas of focus: environmental risks and climate change (55 percent), ethical governance systems (54 percent) and socially conscious business practices (52 percent).
    
2. Return potential. Of course, most investors in any asset class want a return that they’re happy with, and ESG is no different: The top motivator for 39 percent of affluent individuals investing in ESG is higher returns, according to Capgemini. Certainly investors see significant potential for their investments in companies looking to improve society:

• Spectrem found that 65 percent of investors think ESG investments have the potential to do as well as or better than the overall stock market—and those with the highest levels of wealth were most likely to expect market-beating returns.
• Seventy-nine percent of wealthy investors in a different study (by Campden Wealth) said their impact investments either met or exceeded their return expectations—while nearly the same percentage (80 percent) believe there is no trade-off in financial performance with such investments.

What’s more, some data supports those viewpoints. Past performance is no guarantee of future results, of course, but it’s worth noting that compared with funds of a similar size and category, sustainable funds beat their peers more than 60 percent of the time during the five years through 2022, according to Morningstar. Nearly half of sustainable equity funds achieved the top quartile for five-year returns.

One possible reason driving those results: Companies that proactively tackle environmental risks, foster good relationships among their employees and communities, and practice good corporate governance could be exposed to fewer financial risks. And indeed, there appears to be a link between ESG and financial performance. A study by Institutional Shareholder Services ESG notes, “While one can argue that the relationship between ESG and financial performance is perhaps due to the fact that more profitable firms have the resources to invest in areas that positively influence ESG, it could also be that profitability rises as a result of a company better managing its material ESG risks, or it could be a little bit of both.”

What to watch out for

That said, finding legitimately “do-good” businesses to invest in isn’t like spotting the organic label on a carton of milk. There are pitfalls along the way, as well as some issues that make ESG investing more complex and riskier than it might seem at first glance.

One potentially big risk is greenwashing—essentially, when companies mislead or overhype the extent of their ESG-related efforts. Examples of greenwashing might include a business that uses relatively little energy in the first place touting its new energy-efficient operations, or a company sponsoring diversity-related public forums and high-profile events while maintaining a poorly diversified workforce or leadership structure. Other companies might advertise specific steps they’ve taken aimed at generating social benefits but never track results to determine if their actions led to the desired outcomes.

More than four in ten affluent ESG investors cite greenwashing as the biggest challenge with regard to this type of investing in the coming years, while 76 percent of investors surveyed by Spectrem are concerned about the risk of “making an investment that has been greenwashed.”

A related risk is being able to accurately assess a company’s ESG-related efforts to determine if they’re having the type of impact that could make them a potentially strong investment opportunity. ESG investors have set up various criteria and metrics they use to judge companies’ initiatives and score them. However, the standards vary depending on who is doing the assessing—making it difficult to rely on one score or rating as the final word on a company’s overall ESG-ness. What’s more, the ratings might be based on information coming from the companies themselves—creating another opportunity for greenwashing. The good news is that there’s a movement toward a universal set of standards, but we’re not fully there yet—making it tough to know if some ESG investments hold companies that are truly making an impact.

Another potential risk: By avoiding certain investments due to ESG factors, investors may end up becoming heavily invested in a relatively small number of market sectors or securities. That could expose investors to certain unexpected risks.

And of course, ESG investing (similar to traditional investing) may be subject to market risks, data accuracy challenges, regulatory changes, and liquidity constraints—risks that should be carefully considered.

Conclusion

ESG investing is becoming a significant component of some investors’ wealth management plans—including investors with significant assets. Of course, that’s not a good enough reason to make ESG a part of your portfolio. But the fact that this type of impact investment approach is getting attention from investors with sizable wealth does mean you may want to consider it when allocating your capital. The opportunity to own investments that reflect your values and may offer attractive returns is one that shouldn’t be ignored.