October 27, 2022
Over the last decade, people have changed tune about what they expect from companies. Edelman’s Trust Barometer, a survey which aims to understand customer sentiments, shows that social impact is an increasingly important factor in buying decisions for consumers.
Seismic shifts in public opinion on political issues such as climate change, drug addiction, and racism have prompted companies to reinvent themselves for a new generation of politically-attentive consumers. On the stock market, that same reinvention is affecting how investors send their money to work.
Socially responsible investing: A new order
This reinvention has prompted the rise of socially responsible investing, which caters to a generation of investors concerned about their investment dollars being tied up in “dirty money”: bloated oil, tobacco, firearms, and gambling companies. Especially among younger generations, impact investing is being painted as a way to make a ‘real impact.’ That impact is starting to grow: in 2020, assets under management following sustainable investing strategies reached $17.1 trillion.
This came as no surprise to seasoned investors – these same funds posted over $72bn in inflows in Q2 2020. Much of that money went into ESG funds, passively-traded “impact” indexes, which invest in companies operating responsibly. Let’s take a look at ESG funds and their increased prominence in the market.
What are ESG funds?
ESG stands for Environmental, Social, and Corporate Governance. That’s many big syllables that refer to a more simple idea: responsible and sustainable operations of a business. ESG funds have positioned themselves as “funds for good” – they only invest in companies that prioritize environmental, social, and corporate governance initiatives. For example, companies reducing their greenhouse gases, committing to diverse hiring, and supporting certain social initiatives.
ESG funds systematically exclude companies that are not making a positive impact. There’s even a way to score companies on their ESG impact. The idea is that companies with lower ESG scores might be open to risk, liability, or litigation. All of these things could potentially cause problems for a company. Given the increased amount of public scrutiny around companies and their operations, ESG has been adopted as one indicator of how ‘future-proof’ a company is. Companies that don’t get with the times might be relegated to irrelevance or go out of business. Companies that modernize will be well-positioned for success.
Looking to invest more consciously? Connect your broker to start building an ESG oriented portfolio.
Because of the newfound interest, there are lots of ESG funds. Some of the most popular ones take common indexes such as the S&P 500 and put a ‘sustainable twist’ on them. For example: $EFIV, the SPDR S&P 500 ESG ETF, has only 295 of the 500 holdings from the normal S&P 500. However, there are also entire funds dedicated to tracking ESG indexes. $SUSL, the iShares ESG MSCI USA Leaders ETF, tracks an index of 300 large and mid-cap companies which boast the highest ESG ratings in their respective industries.
Why are ESG funds on the rise?
So, why the need for ESG funds? Well, a lot of research shows that companies that implement ESG practices and goals tend to outperform companies that don’t. In 2020, the higher a company’s ESG rating, the higher its returns were. This was also supported by returns in ESG funds, which S&P Global showed had beaten the S&P 500 and Dow Jones Industrial Average in 2020.
That last point deserves attention. Prominent indexes like the S&P 500 and Dow Jones Industrial Average tend to be more traditional. For any indication of that, consider that green energy ‘up-and-coming’ companies like Enphase and Tesla only joined S&P 500 after reporting meteoric rises in 2020. Meanwhile, those same indexes are holding oil and tobacco companies like Altria and Exxon – which have actually held the index back.
However, the main reason ESG funds are on the rise is changing consumer sentiments. Companies in controversial industries are increasingly viewed as contributors to larger societal problems. Increasingly, many people – especially Millennials and Gen Zers – view investment in these sectors as an investment in ‘dirty money.’ This has led to an increase in interest around impact investing and ESG.
Should you invest in ESG funds?
Whether you should include some impact element or ESG investing in your portfolio should ultimately align with your own beliefs. If you are concerned about how we treat the environment, how companies operate and hold themselves accountable, and how companies are contributing to our society, then ESG investing is one way you can put your money where your mouth is.
Other than traditional indexes, an alternative to buying ESG funds is buying thematic funds, or individual stocks with a track record of meaningful ESG strategies. Investing based on your values is a powerful way to put your money to work.
If you’re serious about ESG investing and how that could benefit your portfolio, download Front and connect your broker. You’ll see how high ESG stocks could contribute to your portfolio performance.