Making Your Investment Portfolio Greener: Incorporating ESG
ESG—a term often tossed around, yet frequently misunderstood. This applies not only outside the realm of finance but particularly when it comes to investing and ESG. In this article, we’ll explore the risks associated with ESG investments, the process of incorporating more ethical themes into your portfolio, and, of course, where the returns lie in ESG.
What does it mean to invest in ESG?
ESG stands for Environmental, Social, and Governance. To break it down further:
How a company uses energy, deals with waste, addresses pollution, considers the treatment of animals, and manages environmental issues.
How a company builds relationships with its stakeholders—be it the community, employees, suppliers, etc.
Internal controls, audits, shareholder rights, etc. Essentially, it’s about how the company treats those directly connected to it.
ESG doesn’t necessarily alter what you invest in; it encompasses bonds, equities, commodities, and alternative investments. What changes is the way you screen the securities you invest in, ensuring your portfolio reflects your values.
Nowadays, ESG is increasingly prominent in investors’ portfolios. As topics like climate change, global warming, and renewable energy gain recognition, people want to ensure they invest in securities that support positive change or avoid those that go against their values.
Misconceptions about ESG Investments
As humans we instinctively assume that because we are narrowing down our investment choice based on better values, that in turn we will have to sacrifice some element of return. The truth is, there are strong returns for investors who research and approach ESG investments sensibly.
A common misconception is that having a green portfolio means holding 100% of your securities in sustainable investments. It’s either 100% or nothing. This is far from the truth. Many investors “negatively screen” securities within their portfolio, excluding certain industries like Gambling or Tobacco.
Alternatively, you decide to set a goal for a specific percentage allocation to companies dedicated to creating a positive impact and scoring a strong ESG rating. A process referred to as positive selection.
Positive sector selection is similar to negative screening but involves including sectors aligned with your values, such as renewable energy or companies with low carbon emissions.
The main advantages for the Investor
The obvious advantage that people who adopt an ESG theme into their investments is that they are buying into companies that are in some way creating a positive impact or operate in an ethical and fair manor.
There are more investor specific advantages. One being the stability and resilience of companies with a stronger ESG score. The direct benefit of lowering the volatility of your portfolio and having more resilient stocks in times of adverse market conditions.
Whether you are particular about the securities you invest in or not, you still aim to make a return on the investment you make, that principle will never change. Realistically as a retail investor, you’d be looking to invest in an “ESG ETF” that contains stocks with a strong ESG rating, in order to achieve the diversification necessary to manage risk effectively.
Below are some of the top ESG ETFs.
As you can see, all 5 have produced strong returns in 2023. If you’re a believer that people will continue to trend toward companies with a high ESG score then this might be an area you want to invest in.
The main risks associated with ESG
We touched upon some of the potential advantages but there are of course still risks present that every investor should be wary of.
If an investor choses to go down the ETF or mutual fund route, then it is very important that they research the companies that are held within the fund. Many companies that may be included in an “ESG Fund” might not actually be what you consider as a true ESG stock. For example Amazon, who score highly in corporate governance and data security, have an average carbon footprint and score poorly on labour management.
Many companies have been accused of simply labelling themselves as “Green” but not actually following through with any of their pledges, this is known as greenwashing. Simply making misleading environmental claims for marketing purposes and in an attempt to improve their reputation.
Thanks to the reasons I mentioned above, and the screening process one will go through in order to select the securities for their portfolio, the construction of an ESG portfolio requires an increased amount of time and attention to detail when conducting a thorough fundamental analysis on the companies being invested in.
Not only is this time consuming, but finding the balance between a high ESG score and a strong business model and growth prospects can be difficult process.
Investing in ESG: a tailored approach for every investor
ESG investing is personal, and each investor can take it to the extent they prefer. Whether that means something small, like including a few companies whose values align with yours, or holding a large allocation in a diverse range of companies that meet your ESG criteria. If you have questions about building a portfolio on a particular theme or specific elements of ESG investing, feel free to reach out.
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