ESG and smart investing have gained more attention over the last decade. According to Gallup, 25% of investors have heard about sustainable investing, and 10% say they invest in ESG funds. 48% of investors also say they are interested in purchasing sustainable investing funds.
But what is ESG, and why should investors think about implementing ESG strategies in their portfolios? In this article, we outline the meaning of ESG and how you can implement strategies that will impact the environment more positively and the performance of your portfolio.
What is ESG?
ESG (Environmental, Social and (Corporate) Governance) can help investors understand the impact that their investments have on the environment and whether their portfolios are in-line with their overall ethos.
Many investment platforms in the market do provide scores for stocks that indicate the ESG credentials of a company and allow investors to build portfolios based on these factors.
How is it calculated?
To understand how ESG scores work, it’s essential to understand the four main data sets that constitute an ESG score:
The environmental rating depends on emissions, resource use, and innovation. The number of indicators available for each of these three areas defines the area’s weighting in making up the overall environmental score.
The overall social score depends on four areas: workforce, human rights, community, and product responsibility.
The overall score for governance is calculated based on the scores for management, shareholders and CSR strategy.
The last area that makes up the ESG score is controversies. Controversies across all the ten areas are aggregated into one category score.
The growing interest in the environment has led to companies fabricating their positive actions and ways they are helping the environment, which is also known as greenwashing. When companies greenwash, investors start demanding more transparency from their investment companies about environmental impact and how their actions mitigate the long-term effects.
As we know already, slight changes to the globe’s overall temperatures due to carbon emissions are causing permanent and long-lasting damage to ecosystems. So much so that according to The Global Risks Report 2022, 3/5 of risks identified by business leaders are environmental.
Promoting a sustainable economy can also bring other benefits (such as new investment opportunities), highlighting the importance of investors having easy access and transparency on information related to climate change and other issues. Several initiatives out there, such as GRI and TCFD, can provide a suitable framework for companies to report on these.
How can ESG provide better returns?
Here are a few examples of how ESG may provide better investment returns. A report from Fidelity International in 2021 found a relationship between ESG quality and growth, demonstrating companies with a strong sustainability rating had the highest levels of historical dividend growth.
Looking at three different ETFs and their performance over the last decade can demonstrate the above findings. In the chart below, the blue line represents an ETF which tracks the MSCI World Index but excludes stocks which don’t have strong ESG ratings. The fund designated by the red line tracks the MSCI World Index with no exclusions. The green line represents an energy stock ETF tracker, which is typically less likely to have high ESG scores due to its overall environmental impact.
URTH = iShares MSCI World ETF
XEF = iShares Core MSCI EAFE IMI Index ETF
XEG = iShares S&P/TSX Capped Energy Index ETF
Interestingly, the ETF, which excludes stocks that have less favorable ESG ratings, has seen considerable growth over the past ten years compared to those that didn’t. Although the energy stocks are showing lower growth, there seems to be an uptake over the past year due to recent geopolitical events worldwide. These findings indicate a strong argument for having ESG-focused funds in your portfolio.
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