ESG Investing: An Ethical Approach to Investing

ESG Investing Explained

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Ethics and Investing are probably the two words you don’t often find together from scandals to pollution, greedy executives to human rights violations corporations have carried out many environmental and social harms over the years in the name of profits. This often leaves investors with a tough predicament,on the one hand we need investing in order to increase our wealth and help us accomplish our objectives like retirement or buy a new house but on the other hand investing can enable these organizations to carry out wrongdoings.

Recently we have seen the rise of ESG Investing , an approach that not only considers the financial gain of a position but also the direct or indirect effects a business has on the well-being of others. It is a nice strategy that gained meaningful ground in the recent time even though this form of investing too has its shortcomings. 

So let’s go ahead discuss the topic of ESG Investing which stands for Environmental, Social and Governance investing.

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What is ESG Investing?

Most financial institutions focus on projects which makes money for their shareholders irrespective of its detrimental impact on the environment or society due to which governments have to introduce regulations to ensure corporations consider other factors such as pollution, minimum wages etc, but these regulations are fairly broad in their scope and this leaves a lot of gray areas which regulations don’t account for.

As generations have become more aware and educated about social and environmental issues, investors have taken it upon themselves to support only those companies that align with their own values. This approach is known as ESG Investing.

In the world of stocks people generally consider the environmental and social impact of a firm’s operations. The environmental impact could include pollution and animal welfare while social factors include human rights, employee compensation and community engagement and corporate governance refers to diversity and how a company manages those at the top.

ESG Investing analyzes three considerations and incorporating the findings into standard financial models, so that how a firm is run is considered alongside its profitability and while there is no standardized approach to the practice , there are two broad strategies that are being used:

ESG Investing
  • Negative Screening
  • Positive Screening

Negative Screening

Negative screening involves removing companies from the universe of stocks to be invested in based on certain traits the investors are looking to avoid with harmful social and environmental impact like tobacco, firearms and gambling are all industries which frequently get avoided because of this strategy. Other times this strategy involves removing companies with certain red flags like those with a history of human rights violations or companies that have committed fraud.

Positive Screening

Positive screening involves a more proactive approach and looks to invest in companies that are actively benefiting or supporting positive initiatives while operating their business. This includes renewable or green investing where investors put their money behind wind, solar and other types of renewable energy companies as well as investing in companies with more equal opportunity employment practices and diverse management teams.

Once the universe of stocks has been narrowed down an ESG fund may look to score them based on ESG factors enabling them to identify which companies are doing their part and which ones are not. How a fund weighs these factors against the traditional financial analysis can vary.

Some funds can simply carry out traditional financial analysis and put more of their money into stocks with higher ESG scores while other funds will use the ESG factors as the primary determinant to their investment decisions. Regardless, the approach looks to better balance traditional models with the ethics of holdings themselves.

Pros

ESG Investing is an efficient way of investing into companies that share the same values that you do while also being able to meet your financial objectives, which is not true for ethical investing tools like impact investing and community investing which came more about the ethical side of things and do not assure returns to investors even though they support investments in noble causes.

Hence, ESG investing as a practice has become very popular overtime with many companies like Nike changing the way they do business to have a positive impact on the environment. As a result this sector is expected to experience tremendous growth in the coming years with the amount of money in sustainable mutual funds is expected to double in the next couple of years. 

Cons

As discussed in the above section, ESG investing certainly has a lot of merits but there are some shortcomings which investors need to be aware of before investing these funds.

  • ESG investing is not a standardized approach and you may sometimes find that the ESG fund may not exactly align with all your values. Just like the field of ethics itself where different schools of thought provide different answers to the same important ethical questions, investment firms use varying criteria for analyzing ESG factors and there is no standard which can dictate how lenient a fund can be certain issues. For eg, there are many ESG funds that hold fossil fuel companies and it is possible for an environmentalist to find their fund investing in the most efficient fossil fuel company which may not match with their own values.
  • ESG factors can also be very difficult to analyze as there are a lot of details to consider including a companies operations, their supply chains, their employees and partners, etc. and companies aren’t required to track their ESG performance which means we often have to make our decision based on the self-advertised information put forward by the firm in their annual reports. Not only does it make finding red flags difficult but companies can also greenwash their operations where they take on minor initiatives like donations or provide false promises that give the image of some large ethical operation.
  • Apart from this, there are some financial shortcomings to the investor when it comes to ESG investing. Strict ESG criteria can greatly limit the diversification of your portfolio, an investor who only wants to invest in renewable zero-waste positions will have a much smaller pool of stocks to choose from than other investors and will be heavily exposed to the risk from those companies. 
  • Also, there is an additional cost of ESG Investing, because ESG funds and high-ranking ESG stocks garner a lot of demand they can actually be more expensive. As a result, ESG funds tend to charge a higher fee than traditional funds.
Pros & Cons of ESG Investing

Top Performing ESG Funds in India

India has seen a gradual growth in terms of ESG funds with many funds now being able to complete equity and balanced funds in terms of returns. Let’s have a look at some of the well established ESG funds in India and the return they offer to investors:

Funds3 months6 months1 year3 years5 years
Axis ESG Equity8.5330.0248.05
ICICI Pru ESG7.45
Quant ESG Equity17.42
Quant India ESG Equity13.635.965.3
SBI Magnum ESG Equity11.630.5249.913.514.8
Mirae Asset ESG FOF9.66

Should you Invest in ESG Funds?

According to experts with the risk lowered, investors in such funds stand to benefit from better risk-adjusted returns in their portfolios over the medium to long term.

A strong ESG proposition can help create business value across the enterprise. “E-sustainable practices attract more customers, allows better access to resources, lowers energy and water consumption, and therefore also can reduce operational costs. S-sustainable practices lead to greater social credibility, attract talent, boost employee morale, and build stronger community relations. 

While G-sustainable practices may lead to government support, subsidies, overcoming increasing regulatory pressure, and better investor relations, e.g., in form of better loan conditions or lower capital costs.

Ultimately it is about the sustainability of a business in an ever-changing world. And as the focus shifts to the longevity of a business (and implicitly the valuation of an enterprise), it is likely that ESG investing becomes more mainstream and much more integrated into the security selection process itself.

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