At first, it seemed like everyone wanted to jump on the ESG train. Then they wanted to jump off. If you’re confused over the about-face, read on. This article gives the good and bad of ESG investing so you can decide whether it’s for you.
ESG—What Is It Good for?
No, the answer isn’t “Absolutely nothing (say it again).” Criticism aside (we’ll get to that shortly), ESG funds and ETFs can help investors align their portfolios with their values.
ESG stands for environmental, social, and governance. Most people understand the practice to mean rating companies on how well they live up to ESG standards. For example, do they promote workplace diversity? Are they implementing carbon-neutral policies?
Done well, we believe that ESG and other values-based investment processes like socially responsible investing (SRI) can help lead to change for the better in corporations and the world.
In addition, a portfolio that reflects an investor’s values can help keep them invested when markets get volatile. Consider this quote from Forbes:
“There is a consensus that investors who can form some sort of attachment to their funds tend to stick with them when things get a little turbulent in the markets, Overall, that’s probably a good thing for most long-term investors who need to have a buy and hold strategy. That’s a very valuable behavioral component that ESG investing brings to the table.”
So if an ESG-based portfolio can help you invest your values and reach your goals, what’s the problem?
Well, there are a few concerns …
The Downsides of ESG
Here are a few key issues you need to know before diving into ESG.
1. Companies can get a passing grade even when you disagree with their policies. ESG investments ideally encourage companies to do better. But portfolios can still contain corporations that you think fall short.
You may find yourself invested in a technology company that is creating waste cesspools from rare earth mining. Or take this example from a Bloomberg article on ESG ratings. It reports that McDonald’s had 54 million tons of emissions in 2019—an increase of about 7% in four years. Yet that same year, ratings company MSCI gave McDonald’s an upgraded score for its environmental impact.
“Why?” the article asks. “Because MSCI determined that climate change neither poses a risk nor offers ‘opportunities’ to the company’s bottom line.”
This leads us to our second point:
2. Ratings are not standardized. You may think ESG scores are based on how well the company benefits the world. But they may be based on how well the policies boost the company’s profits.
Some would say the distinction doesn’t matter. What benefits the company benefits the world—and that can be true. But did the McDonald’s emissions help us globally? Every individual must come to their own answers to such questions.
Scores can vary widely based on the company providing them. Says the same Bloomberg article referenced above:
“Each ESG rating provider uses its own proprietary system, algorithms, metrics, definitions, and sources of nonfinancial information, most of which aren’t transparent and rely heavily on self-reporting by the companies they rate. No regulator examines the methodology or the results.”
3. Fees can be higher, and diversification can be less. Since ESG funds aren’t tracking an index, they’re not taking a passive approach. It requires research to decide which companies get included and which get cut. This can lead to higher fees.
ESG can also lead to less diversification. Many ESG funds have tanked in 2022 for the same reason they did great before: They are often knee-deep in technology companies, which had a stellar run until they took a hit this year.
Having a properly diversified portfolio (or owning a little bit of everything) can help insulate investors from short-term market swings while they work toward their long-term goals.
So Do You Invest or Not?
If this article proves anything, it demonstrates the importance of researching before investing.
Follow MSN’s advice and make sure to read the fund or EFT prospectus and disclosure materials to see whether the definition of ESG is your definition. Compare fees, understand diversification (or lack of), and read annual reports.
Finally, understand what you’re willing to sacrifice vs. what you stand firm on. Do you refuse to have certain highly profitable companies in your portfolio? Do you accept that their exclusion may mean you earn fewer returns than, say, a portfolio tracking the S&P?
The allure of ESG is that it promises to make values and money compatible when they are so often held in opposition. Consider talking with a fiduciary, fee-only financial advisor to find the right balance for you.
Schedule a complimentary consultation with one of our fee-only financial planners to discuss your personal situation.
This material was prepared by Kaleido Inc. from information derived from sources believed to be accurate. This information should not be construed as investment, tax or legal advice.
