Investing

Can you do well by doing good? Americans have bet $17 trillion on sustainable investments

ESG funds focus on firms that score high marks on environmental, social, and governance metrics.

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If your aim is to make a societal or environmental impact by directing your investment dollars to companies who uphold your principles, you're far from alone. More and more investors are speaking with their wallets each year, and companies are taking notice. As a result, principled investors don't have to sacrifice returns when investing to make a difference, says Brian Walsh, senior financial advisor at Walsh & Nicholson Financial Group.

"For someone worried about long-term returns, look at trends in the political climate, social climate, and understand that as companies begin to meet the needs of this new generation, they're going to be rewarded by the younger generation of investors," he says.

So-called sustainable investing, where investors aim to use money in their portfolio to make the world a better place, is among the biggest trends in the financial world since the invention of index mutual funds. According to a recent report from sustainable investing research and advocacy group US SIF, U.S. investor assets in sustainable investments totaled $17.1 trillion at the start of 2020, up from $12 trillion at the start of 2018, and up 25-fold from when the firm began tracking investment data in 1995.

An up-and-down market hasn't slowed things down in 2020, either. Through the first half of the year, investors plunked nearly as much money into ESG mutual funds and ETFs as they had for all of calendar year 2019, according to Morningstar.

Here's everything you need to know about directing investment dollars toward companies whose causes you believe in: what they are, how they work, and how you can go about adding such a strategy to your portfolio.

ESG investing: How to do good while doing well

The main term you'll hear when looking into sustainable investing is ESG, which stands for environmental, social, and governance practices, the three areas on which investors assess companies when deciding how to invest.

At the same time, people who put money in to such companies still expect their investments to provide returns. The idea is to do good while doing well.

Funds that fall under the ESG banner can focus on any one of the three letters, or all three. Investment managers typically rely on ESG ratings from one of a handful of prominent firms that crunch the data, which includes MSCI, RobecoSAM, and Morningstar-owned Sustainalytics.

No two raters' criteria, or the importance they assign to them in their rating system, are the same. But in general, you can expect a few common characteristics among firms that get high ESG ratings:

  • Environmental: High scorers make efforts to reduce their carbon footprint and generally minimize their negative impact on environmental resources. These firms have responsible land and water use policies. They may be making major investments in key environmental areas such as renewable energy and green buildings.
  • Social: Companies that treat their employees and customers well earn high social ratings. Such firms take steps to eliminate discrimination in their workplace and business practices, minimize HR issues, and score top marks for product and employee safety.
  • Governance: Measures here include gender and racial diversity on corporate boards as well as executive pay structures, which should be reasonable and well-defined. Companies that practice good governance exhibit transparent accounting, solid business ethics, and avoid anticompetitive business tactics.

Companies are graded on a sliding scale according to their industry. For example, under MSCI's methodology, the ratings for a beverage company such as Coca-Cola would emphasize water usage, packaging material and waste, the health and safety of its employees, as well as the nutrition and health impact among Coke's customers.

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How socially responsible investing works

Another acronym you may run across when researching these investments: SRI, which stands for socially responsible investing. The precursor to modern ESG investments, SRI funds seek to filter out so-called "sin" or "vice" stocks whose chief business practices may misalign with investor values. Funds that invest based on religious principles, for instance, may exclude companies who derive the bulk of their revenues from alcohol, tobacco, gambling, and pornography.

These days, it's not just the puritans screening out the bad actors. Several ETF firms have released funds that track broad market indexes, with some firms conspicuously missing. "These ETFs are based on well-known benchmarks, but exclude some of the poster-children of what shouldn't be in an ESG fund," says Todd Rosenbluth, senior director of ETF and mutual fund research at investment research firm CFRA. "They're ESG-lite."

The Vanguard ESG U.S. Stock ETF (ESGV), for instance, tracks the CRSP U.S. Total Market Index — a broad stock market benchmark — but excludes businesses in controversial industries, such as nuclear power, fossil fuels, alcohol, tobacco, and gambling. Companies that earn low marks for diversity are also disqualified. The SPDR S&P 500 ESG ETF, which debuted in July, takes a similar approach with the S&P 500.

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Returns on such funds are likely to hew relatively close to their underlying non-ESG index, since many of the portfolio constituents are the same, says Rosenbluth. If you're looking to dip your toes into the ESG waters, these are a good, low-cost ways to start, he says.

"Historically, people used to think that you had to pay a premium for an ESG approach," he says. "These funds are cheap by any standard and are unlikely to significantly underperform."

The Vanguard and SPDR funds charge expense ratios of just 0.12% and 0.10%, respectively. That's right in line for most passive funds, and much cheaper than the typical actively managed fund.

Modern ESG funds: Supporting companies with good values

Early on, investors were skeptical not only of SRI funds' costs, but also of their mandates: Was it really worth it to leave out certain companies, and their potentially juicy returns, in the name of social responsibility?

Modern ESG strategies may still exclude a few types of companies, but they generally revolve around selecting stocks with the best ESG track records. That could even be an advantage: Portfolio managers at ESG funds argue that high-scoring firms are less exposed to risk, say, from lawsuits resulting from poor environmental or consumer practices, and should benefit financially over the long term from sound corporate governance.

These funds are cheap by any standard and are unlikely to significantly underperform.
Todd Rosenbluth
senior director of ETF and mutual fund research

These strategies should also benefit because a surging wave of younger investors care about these issues, says Walsh. "Companies that report really strong ESG characteristics are addressing issues that are pain points for a generation of investors that is going to be inheriting the largest transfer of generational wealth we've ever seen," he says.

Investors looking for a modest ESG tilt might start with the iShares ESG Aware MSCI USA ETF (ESGU), which charges an expense ratio of 0.15%. The portfolio mostly mirrors a broad U.S. stock index but excludes firms from certain industries and tilts its portfolio weightings toward the highest-scoring ESG firms in the index.

For a more comprehensive ESG investment, consider an active mutual fund, such as those offered by Parnassus Investments, which incorporates ESG criteria into its stock-picking strategy.

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If you're passionate about a particular cause, search for an ESG ETF with a narrow focus, says Walsh. "If you believe in clean energy, choose a fund that will filter out companies that aren't on the leading edge of clean energy," he says. "Every fund has different metrics, but you'll likely see a company like NextEra promoted rather than the likes of Exxon or Chevron."

If that was your particular pet cause, you would have had a good year investment-wise. The iShares Global Clean Energy ETF (ICLN) and the Invesco Solar ETF (TAN) have returned 103% and 173%, respectively, so far in 2020.

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