Understanding ESG Fund Investing – Meaning, Market and Myths
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Written by Tavaga April 13, 2021. Please note, this article has been edited for content.
What does ESG in investing stand for?
ESG stands for Environmental, Social, and Governance.
ESG investing is an up and coming style of sustainable investing in the markets. Sustainable investing means constructing a portfolio of stocks that stand out in terms of environmental, social, and governance factors.
Financial risks and non-financial risks pose a threat to the company’s bottom line. ESG investing aims to mitigate the forms of non-financial risk which are significant in the long term. Companies are going-concern entities, and the companies that acknowledge the long-term impact on their surroundings are more likely to stay equipped for any uncertainty that may arise in the future. Therefore, ESG investing aims to take advantage of superior returns from such selected companies.
Why is ESG investing trending?
With every passing year, the globe has been setting records for causing adverse climate change. Global warming is actively contributing to melting glaciers, and the corporations are directly related to the emission of harmful gases into the environment. Australia had to deal with an adverse eventuality of wildfires that lasted for six months due to extreme heat. Indonesia witnessed the wrath of rising sea levels during the Indonesian floods. The cities closer to the coast are facing the everlasting threat of getting submerged. The cities away from the coast are dealing with drought and extinguishing groundwater levels.
As emerging economies consume more resources to achieve new levels of growth, ensuring sustainable growth is of utmost priority. ESG investing strives to recognize companies with good practices toward their physical and social environment.
After all, how does one expect a company to last if the ecosystem enabling the company vanishes into thin air?
Practices prevalent in capital markets follow the money. Therefore, the idea of ESG investing is to reward sustainable business decisions. As more institutional investors and sovereign funds focus on stocks with high ESG scores, more companies are likely to welcome the trend.
What are the ESG funds?
ESG funds are mutual funds that fall under the category of thematic funds. ESG funds adhere to the theme of investing in the equity of those companies that showcase:
- Environmental-friendly business practices
- Positive social impact by the company products or practices
- Discipline in corporate governance and company ethics
The investment philosophy for ESG funds may be multi-faceted. One approach may be to directly exclude the ‘sin’ stocks, for example, stocks of companies marketing tobacco, alcohol, weapons, etc. Another approach is to place importance on impact investing. Impact investing is not only about generating financial returns but also about incentivizing positive environmental or social change. In essence, impact investing means providing capital to address widespread concerns that affect society as a whole.
ESG funds have self-developed methodologies of assigning ESG scores to companies and deciding which company qualifies to be a part of the fund. Typically, ESG funds prioritize technology, financial services, and consumer sectors and avoid energy, mining, and utility sectors. There are no norms for sector exposures governing such funds. However, most ESG funds place importance on a company’s carbon footprint, emission norms, resource utilization, and governance.
How is the global market for ESG funds?
The fiscal year 2021 has been groundbreaking for ESG funds globally. According to a report from Morningstar, both the number of funds and assets under management of such funds have doubled in the past three years. As of the second quarter of FY21, the funds guided by sustainable investing are managing approximately $250 billion. The US has followed in the footsteps of Europe and currently represents around 20 percent of the global AUM for ESG funds.
Investors across the globe have exercised caution by adopting the socially responsible way of investing. It is only poetic justice that ESG funds find their break whilst the pandemic grips the globe.
What are the concerns underlying ESG investing?
- The data to holistically assess a company’s ESG footprint is not easily attainable. There is a cost associated with mining such data. Therefore, to accurately judge a company in terms of ESG parameters, there has to be extensive reporting on the company’s part and thorough research on the analyst’s part
- The method to determine the ESG scores for a company is highly subjective. In the absence of a streamlined framework and established norms, the validity of a stock being an ESG fit will always remain under question
- Few companies may indulge in window-dressing of results to be considered an ESG-compliant firm. Filtering through such companies will depend on the fund manager’s competence
- Most of the funds will not have a track record of performance. Therefore, the decisions of the investor will have to be based solely on the market view and personal investment preferences
Busting myths surrounding ESG Investing
‘ESG means negative screening’
ESG investing is often confused with ethical investing. Both investing styles are separated by a fine line. Ethical screening employs negative screening, which clearly states the stocks that the fund will not invest in. ESG investing involves positive screening adopting an inclusive approach.
‘ESG means values’
ESG investing is more than just values and ethics. ESG investing is a way of risk mitigation for the portfolio. Historically, companies that made the headlines for the biggest scandals were the ones that did not prioritize ESG parameters.
‘ESG is just a jargon’
ESG investing is more than just a public relations project. The global ESG funds have witnessed major inflows over the past years which goes to show that investors are putting money where their mouths are.
‘ESG means foregoing superior returns’
ESG investing is carried out with a long-term view. Critics of ESG investing dismiss the recent outperformance of sustainable funds calling it premature. However, ample research across the globe points to better risk-adjusted returns for ESG strategies.
ESG-oriented funds are well-diversified across sectors and certainly qualify to form a part of an investor’s portfolio. Given the evolving nature of ESG investing, a risk-averse investor may decide to wait out the transitory phase and enter the market when enough alternatives are available.
Sources:
1. Header photo from Unsplash