The world of finance and investments is notorious for its extensive use of jargon. With a goal to enhance financial literacy and make the world of money more transparent, we have our “monthly jargon” articles that focus on debunking financial terms that are often used sans explanation. This month, we’re discussing an investing method that has gained noticeable momentum and popularity throughout the past few years: ESG investing.
What is ESG?
ESG stands for environmental, social, and governance, and these three principles comprise a set of standards that socially conscious investors can leverage to evaluate potential investments. ESG criteria have blossomed in popularity in recent years, as people have begun to express a strong interest in thoroughly knowing and understanding the companies they are investing in, with a desire to put their money where their values are.
ESG evaluation is used to enhance traditional financial analysis, and although social awareness is a forefront goal for ESG investing, the main objective remains financial performance. The concept behind ESG investing is that investments with strong ESG scores have the potential to drive positive returns, while investments with weak ESG scores could signal poor returns in the future. By evaluating corporations based on ESG factors, investors can weed out companies that may be assuming the greater financial risk – in the form of supply chain issues and overall performance, for example – because of their lack of focus on environmental issues, while also discovering investment opportunities that they have a genuine care for. Some of the environmental factors that play into ESG evaluation include energy usage, waste production, climate change, animal welfare, and natural resource preservation. A few of the social aspects that are examined in ESG investing involve employee and stakeholder relations, human rights, health and safety, and community interactions. Lastly, a sample of the governance elements involved in ESG evaluation encompasses shareholder rights, quality of management, disclosure, and transparency, and board independence.
Due to the influx in popularity of ESG-sound investments, many brokerage firms, mutual funds, and robo-advisors now offer specific investment vehicles that adhere to ESG guidelines. Exchange-traded funds (ETFs) are a common way to incorporate ESG-sound investments into a portfolio. ESG-focused ETFs select stocks based on companies’ ESG practices and traditional financial factors with the initiative of investing for social good. These ETFs enable investors to implement healthy diversification among a variety of carefully screened companies with sound ESG scorecards, as an alternative to investing in a single environmentally conscious company.
ESG vs. SRI vs. Impact Investing
As a growing number of investors want to see their money go towards companies that are not only profitable but also reflective of their values, new criteria for evaluating corporations have been put into practice. Three investment styles have led the way include ESG investing, socially responsible investing (SRI), and impact investing. Although ESG investing is often used synonymously with socially responsible investing (SRI) and impact investing, these methods have a few differences that impact how your portfolio should be structured and which investments are most suitable for meeting your ethical investment goals.
As stated above, ESG investing involves evaluating a company’s environmental, social, and governance principles – as its name entails – in addition to traditional financial assessments. In contrast to ESG investing criteria, socially responsible investing (SRI) involves actively selecting and removing investments according to specific ethical guidelines, and impact investing aims to help businesses fund a certain project or initiative that seeks to positively benefit society. The underlying motives of SRI could be anything from religion and political beliefs to personal values, and the goal is to generate positive returns without sacrificing one’s social conscience. SRI essentially takes ESG a step further by adding an additional layer of screening to investments that involves one’s personal beliefs and sentiments. With impact investing, positive outcomes are at the forefront of importance, and this style of investing really looks towards helping businesses that have specific goals aimed to benefit society and the environment, regardless of success.
Final Points
With the recent trends in ESG investing, it has become clear that investing is no longer exclusively about financial returns. People care about what their money is going towards, and they feel more confident in their investments knowing their funds are contributing to a bigger story that involves taking care of and nurturing the environment, the people in their communities, and the employees behind the scenes. As the desire to invest ethically continues to grow more pronounced each year, keep in mind that effectively implementing ESG investing can be a difficult task, especially when it comes to matching your ESG initiatives with your overall risk profile and investment goals. It is always prudent to consult your financial advisor before leveraging a new investment strategy.
Investments are subject to risk, including the loss of principal. Environmental, social, and governance (ESG) criteria are a set of non-financial principles and standards used to evaluate potential investments. The incorporation of ESG principles provides a qualitative assessment that can factor heavily into the security selection process. The investment’s socially responsible focus may limit the investment options available to the investor. Past performance is no guarantee of future results.
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