ESG Investing – For the Socially Responsible Portfolio

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Our society has become increasingly aware of how our individual actions influence the world around us. Now more than ever, Americans are making an effort to “go green,” speak out for the underrepresented, and make the world a better place to live. With that, consumers and investors have become increasingly adamant about contributing to worthy causes—not only do buyers want to shop local and support the small business owner, but they want to invest in companies that reflect their personal values.

In short, people want to put their money where their mouth is.

When it comes to investment strategies, the term “ESG investing” has gained a lot of traction. Most people define ESG investments as ones that improve the environment or benefit society in a positive way, but the true definition is a little more complex.

In this blog, our team at Strata Capital will tell you everything you need to know about this financial buzzword and how it applies to your plan.

What exactly is ESG investing?

ESG stands for environmental, social, and governance, and it refers to a ranking system that uses these three categories to classify companies as sustainable investment opportunities. (The term “sustainable” is used broadly here to refer not only to environmental longevity, but a positive impact in each category.) The rank (or score) a company receives helps investors determine whether the company is worthy to be included in a portfolio of sustainable investments.

  • A company’s environmental ranking considers how the company contributes to the conservation of the natural world.
  • A company’s social score reflects the treatment of people inside and outside the company.
  • Governance considers a company’s operations from an ethical perspective.

Here are some of the specific factors that determine a company’s ESG score:

table of factors that determine a company’s ESG: Environment, social, Governance

In general, the higher the ESG score, the more sustainable the company (and therefore the investment).

Is ESG different than SRI (socially responsible investing)?

Yes and no—ESG is the grading system used to measure companies in these categories, while SRI refers to the act of using an ESG-based grading system to choose companies or funds to include in portfolios. So if you’re investing in companies that have a high ESG score, you’re probably partaking in what you would consider socially responsible investing.

That said, socially responsible investing is a general term that encompasses environmentally sustainable investing, impact investing, or ethical investing. SRI investing can differ depending on the investor’s definition of what is “socially responsible.”

Some investors (or wealth managers helping choose investment accounts) use an exclusionary-only approach. This strategy, rather than seeking value-driven investments, simply avoids investments that don’t align with an investor’s values—like companies that produce tobacco, alcohol, or firearms.

So while you might define socially responsible investing as avoiding tobacco investments, others might take a more comprehensive approach.

How is a company’s ESG score determined?

Each company is compared to others in its industry, so there’s no numerical threshold for what qualifies a company as an ESG investment. Companies are generally considered part of a sustainable investment strategy when they have a higher ESG score than their peers in the three qualifying categories. Depending on who is ranking the company, the precise score or ranking can vary, and most analysts use a percentile system rather than a specific score.

Who determines a company’s ESG score?

ESG scores aren’t regulated by one particular authority, so there are lots of companies that use their own grading systems to measure a company’s ESG qualification. MSCI is one of the largest independent providers of ESG ratings, and they create sub-categories within the three main categories (environmental, social and governance) that each carry their own weight to determine a company’s final percentile ranking.

How can I find out a company’s ESG score?

Unfortunately, it’s not always easy to find a company’s ESG score, since much of the research and data is sold to institutional firms, rather than distributed for public consumption. There are a few websites like Sustainalytics where you can search for companies’ scores, but they typically don’t disclose why the score is high or low or where the company ranks in individual categories. However, most publicly traded companies have an ESG section on their website where consumers can investigate their ranking.

Should I consider ESG scores when shaping my investment strategy?

There are pros and cons to focusing solely on companies with high ESG scores. The main benefit, of course, is that you’re supporting companies with values similar to yours (assuming you agree with the standards of the ESG scoring system). And because this is increasingly important to many investors, it can also benefit your portfolio from an economic standpoint. Investments into ESG funds have increased dramatically in recent years, which has caused them to outperform lower-scoring companies—which in turn makes them a more viable investment.

But just because a company has a low ESG score, that doesn’t mean it’s a bad company or a bad investment. By excluding low-scoring companies, you could miss opportunities to invest in lucrative companies that could benefit your portfolio.

If it’s important to you to invest sustainably, the most important thing to understand is your definition of “sustainable” and how it compares to an ESG score. Your values may not align with an analyst’s definition of sustainable, so if you’re relying heavily on an ESG score to influence your decisions, make sure you do as much research as possible.

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