Many of us may have heard of one of the latest trends in investing – ESG. But what is ESG? Is it beneficial to your portfolio returns? This article will answer these questions from my perspective as the HIG 2022 Summer Intern. But first, what does it mean?
ESG stands for three different elements of a company’s operations:
- Environmental (factors affecting the climate and natural habitat)
- Social (factors affecting stakeholders like employees, suppliers, shareholders, and the society they operate in)
- Governance (the National and International regulators of the business)
ESG is essential to know about today because investors have increasingly started to apply certain non-financial factors when evaluating companies for investment.
ESG ratings attempt to assign a quantifiable value to a company depending on the impact the company has with respect to any of these three factors. Often measured on a scale of -100 to +100 – a positive score is intended to indicate a favorable impact, and a negative score is intended to indicate a potential risk in these areas.
For example, within the ESG matrix’s social governance sector, a company may be given a positive value for increasing diversity hiring in their workforce and assigned a negative value for having no/low female representation in their upper management. In the ESG thinking, sub-par Human Resource policies could lead to potential future lawsuits, theoretically reducing the company’s future expected return and share price.
An issue with these ratings is that things can get confusing quickly. Consider, what happens if Company X scores low on the social scale due to a lack of diversity hiring but performs high in the environmental segment by lowering carbon emissions. Let’s say that Company X comes out with an excellent overall ESG score. With a high ESG score on paper, investors might invest in this “good” company, not knowing that it is scoring high in Environmental but low in Social. In my opinion, investors can be easily confused by high ESG scores, investing while blind to unhighlighted risks.
Additional questions arise about investing in an ESG strategy because there is no standard way of calculating ESG scores. There are numerous rating agencies (MSCI, Sustainalytics, RepRisk, ISS, etc.) that assign ESG ratings to companies. Each of these agencies has a different formula and factor input data and related variables differently to arrive at their score. This means that companies on different rating scales cannot be compared with one another.
So how, as an investor, can you navigate the world of ESG investing?
Ratios like EPS (earnings per share) and EBITDA (earnings before interest, taxes, depreciation) are standardized. These measures are easy to calculate and to use when comparing companies. By contrast, ESG ratios are often opaque and time-consuming to calculate, and therefore, more expensive to apply. This can result in ESG Funds being comparatively expensive to most Index funds without any indication of higher overall performance. ESG funds, because they can remove entire segments of the market – for example, fossil fuels – are often less diversified than most index funds leading to a greater concentration of risk. This could lead to lower returns and higher volatility for the investor.
Because ESG is still a relatively new concept, relatively few funds in this segment have a track record of 20 years or more to judge them accurately. So, the question remains – what do investors do If they want healthy returns but still wish to help society? They may be hard-pressed to choose one over the other and feel they must compromise on either returns or activism.
For some investors, investing to create change brings them happiness and satisfaction rather than maximizing their investment returns. ESG investing may be perfect for them. However, investors hoping to meet or exceed market returns may be disappointed.
One compromise that may leave them satisfied would be to invest in a diversified manner and use some of their income or investment returns to donate directly to specific causes or charities where they want to make a difference. This could also lead to tax benefits for the investor through using a Donor Advised fund, and the potential for higher expected returns through lower investment costs.
Another option is to support society through non-monetary means like raising awareness through volunteer work, changing individual consumption, or directly supporting activists who champion change by joining their work and helping out in their agendas.
I hope that I have provided a better understanding and more clarity on ESG practices so that you can choose the investment philosophy that best suits you!