ESG stands for Environment, Social and Governance. Increasingly investment managers and investors of all types are using ESG screens as a metric when deciding on companies to invest in. There are a number of firms providing ESG rankings of not only individual stocks but also for many mutual funds and ETFs. Notable among these rankings are those provided by Morningstar.
What is ESG Investing?
ESG is an outgrowth of the SRI or socially responsible investing movement. SRI investing selects or eliminates investments that adhere or don’t adhere to certain ethical guidelines. These guidelines could be based on religious beliefs, production of weapons or production of tobacco among others.
ESG investing is also a form of SRI but takes a more pragmatic approach to the ESG screens. A company’s performance in areas like environmental, social and governance can be an indicator of the quality of that company’s management. For example, a company that eliminates environmental risks to its business can help improve its bottom line by eliminating the financial costs of an environmental incident both in terms of remediation costs and potential fines from regulators.
Why is there a rise in ESG investing?
Climate risk is definitely a factor in the increased interest in ESG. Beyond any concerns that investment advisors or investors may have about the impact of climate change on the environment, climate related events can have an impact on the bottom line of many companies. Examples include:
- Droughts reduce harvest yields on crops. This can impact the suppliers as well as the food production supply chain.
- Reduced snowfall totals can impact the profits of ski resorts and companies that make ski equipment.
- Hurricanes and other weather events can destroy buildings and industrial property.
The interest in ESG grew in 2020, ESG funds added over $51 billion in assets in 2020, this addition is double the increase from 2019 according to data from Morningstar. In general, the focus on ESG factors grew during 2020, especially as they relate to employee safety and supply chain issues that plagued so many businesses.
Benefits & Risks of ESG investing
There are both benefits and risks involved with a focus on ESG investing.
The benefits include:
- Companies focusing on governance issues will tend to have fewer management conflicts of interest, broader diversification in their management ranks and in their boards. These are all factors that can lead to a stronger bottom line.
- Companies focusing on social issues tend to have better employee and shareholder relations efforts, and also focus on employee health and safety. All of these efforts can lead to improved moral and transparency, potentially benefiting the bottom line.
- Companies focusing on environmental issues tend to avoid issues related to their products causing pollution and likely have a plan to deal with the impact of climate change on their business.
The risks can include:
- According to a study by the Wall Street Journal. The average ESG fund is more volatile than the S&P 500. This could be attributable to a higher level of small cap risk taken on by most ESG funds according to this study.
- The study also found that many ESG funds can have a concentration risk as the largest holding in a number of ESG funds made up 10% or more of the portfolio.
- Adhering to ESG principles can lead to a portfolio that may not be as well diversified as might be appropriate for an investor due to ESG investing’s focus on certain market sectors and industries.
Opportunities for investors
ESG presents opportunities for investors. One such opportunity is investing in green data centers.
According to the Global Green Data Center Market Report, green data centers are expected to grow about 19% through 2026 and perhaps beyond. Green data centers use less energy than traditional data centers. The continued growth in the use of data for almost everything, coupled with continued concerns about climate change provides a perfect storm scenario for the growth of green data centers worldwide.
As far as incorporating ESG investing into your portfolio there are a few ways to do this. Investing through a fund is one route. There are a number of ESG funds and that number is growing. In going this route, it is important to ensure the fund fits with your overall investing strategy.
Individual stocks that fit into some portion of the ESG space are another way to go. Adding ESG screening criteria to your stock selection process can be another screen to consider. It’s important to evaluate any stocks that meet your ESG criteria on their overall fit with your portfolio strategy as well.
Contact your Wedbush advisor to discuss ESG investing and how it can fit into your overall investing strategy.
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