ESG for Beginners: Environmental, Social and Governance Investing - NerdWallet (2024)

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What is ESG?

Environmental, social and governance criteria, or ESG, is a framework companies use to evaluate their sustainability. Environmental factors look at the conservation of the natural world, social factors examine how a company treats people both inside and outside the company and governance factors consider how a company is run. Here are some examples of what each ESG category covers:

Environmental

  • Carbon emissions

  • Air and water pollution

  • Deforestation

  • Green energy initiatives

  • Waste management

  • Water usage

Social

  • Employee gender and diversity

  • Data security

  • Customer satisfaction

  • Company sexual harassment policies

  • Human rights at home and abroad

Governance

  • Diversity of board members

  • Political contributions

  • Executive pay

  • Large-scale lawsuits

  • Internal corruption

  • Lobbying

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ESG investing

ESG investing is a form of sustainable investing that considers environmental, social and governance factors to judge an investment’s financial returns and its overall impact. An investment’s ESG score measures the sustainability of an investment in those specific categories.

According to the US SIF Foundation’s 2022 Sustainable Investing Overview, U.S. there are $8.4 trillion dollars in sustainable investing assets.

» Ready to get started? Jump to learn how to build an ESG investing portfolio.

ESG for Beginners: Environmental, Social and Governance Investing - NerdWallet (4)

ESG investing benefits

Aside from having a more sustainable investment portfolio, ESG has other compelling benefits.

Potential for high returns

A 2019 white paper produced by the Morgan Stanley Institute for Sustainable Investing compared the performance of sustainable funds with traditional funds and found that from 2004 to 2018, the total returns of sustainable mutual and exchange-traded funds were similar to those of traditional funds. Other studies have found that ESG investments can outperform conventional ones.

JUST Capital ranks companies based on factors such as whether they pay fair wages or take steps to protect the environment. It created the JUST U.S. Large Cap Diversified Index (JULCD), which includes the top 50% of companies in the Russell 1000 (a large-cap stock index) based on those rankings. Since its inception, the index has returned 15.94% on an annualized basis compared with the Russell 1000’s 14.76% return.

» MORE: Check out these ESG-based portfolios

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ESG for Beginners: Environmental, Social and Governance Investing - NerdWallet (5)

Lower risk

The same Morgan Stanley study found that sustainable funds consistently showed a lower downside risk than traditional funds, regardless of asset class. The study found that during turbulent markets, such as in 2008, 2009, 2015 and 2018, traditional funds had significantly larger downside deviation than sustainable funds, meaning traditional funds had a higher potential for loss.

ESG funds have even managed to post strong performance during 2020. Of 26 sustainable index funds analyzed by investment research company Morningstar in April, 24 outperformed comparable traditional funds in the first quarter of 2020 (and the beginning of the COVID-19 pandemic).

ESG investing vs. socially responsible investing vs. CSR

Another common term for the process of creating a sustainable investment portfolio is socially responsible investing, or SRI. While SRI and ESG both seek to build more responsible portfolios, there are a few differences between the two terms.

ESG is a system for how to measure the sustainability of a company or investment in three specific categories: environmental, social and governance. Socially responsible investing, ethical investing, sustainable investing and impact investing are more general terms. Often, “socially responsible investments” are measured using an ESG-based grading system.

Historically, certain forms of sustainable investing varied in how they created their portfolios. For example, SRI used an exclusionary-only approach to filter out investments some considered immoral, like tobacco or alcohol. ESG investing excluded those same investments, but also included companies deemed to be creating a positive impact.

The larger the world of sustainable investing has grown, the more those terms (among others) have been used interchangeably. You’ll see providers who offer a “socially responsible” portfolio that includes ESG funds (as opposed to just excluding certain investments), and ones with the same title that use a solely exclusionary approach. That is why it’s important to look into the methodology used to create a portfolio — no matter what it’s called.

CSR, or corporate social responsibility, is a business practice taken on by a company to improve a local community, the environment or society at large. Beyond helping their cause, CSR initiatives can improve a company's public opinion. CSR initiative planners may take ESG factors into consideration when mapping out their CSR strategy.

ESG investing examples

Investing in ESG can come in many forms: You can invest in an ESG fund or a stock that has a high ESG score. Here are a few ESG investment examples from our list of the best ESG funds:

  • 1919 Socially Responsive Balanced A (SSIAX)

  • Pax Large Cap Fund Institutional (PXLIX)

  • Thornburg Better World International I (TBWIX)

  • Parnassus Core Equity Investor (PRBLX)

  • iShares MSCI USA ESG Select ETF (SUSA)

Types of ESG investments

There are several kinds of ESG investments, but here are a few of the more popular ones and how to research them.

ESG stocks

It’s usually a good idea to avoid a high percentage of your portfolio being held in one or a small handful of individual stocks, but if you really like a particular company (and you think it will perform well over time) you may want to buy its stock. Some companies offer an impact report, which will highlight any sustainable or cultural initiatives they’ve implemented and how they handle issues such as carbon emissions. If you want to know how a company scores in terms of its work environment, check out a third-party site such as Glassdoor. You’ll also want to look at more typical factors such as revenue and net income. Learn more about how to research stocks.

ESG mutual funds

Funds can fill out your portfolio quickly, and can diversify your holdings instantly. The number of ESG funds has surged in recent years. According to Morningstar data, there were 303 open-end and exchange-traded funds in 2019, up from 270 in 2018. Some of these funds focus on a particular issue, such as green energy, making it easy to personalize your portfolio’s area of impact. If your broker offers a mutual fund screening tool, you can compare different funds to see how their ESG ratings stack up.

To learn about the specific details of a particular fund, such as what companies the fund invests in, you’ll want to look through its prospectus. This document should be available on your online broker’s website, and will include other helpful information like the fund’s expense ratio. Expense ratios are annual fees taken as a percentage of an investment. To figure out how much you’d pay to own a specific fund, you can use a mutual fund calculator.

ESG investing: How to get started

Starting a portfolio and filling it with environmentally, socially and governance-minded investments doesn’t need to be difficult. And since there are more ESG investments than ever, you’ll have lots of options to choose from. Here’s how to build an ESG portfolio.

1. Choose to DIY or get some help

If you want to create an ESG-style investment portfolio, you’ll have to decide whether you want to do it yourself by picking specific ESG investments or find a robo-advisor that will do the work for you.

A. I want to find my own ESG investments

If you like the idea of reading up on a company’s sustainability initiatives or ensuring a fund’s companies are in alignment with your moral compass, you may want to build your own ESG portfolio. If you need a brokerage account, here's how to open one. Keep in mind, some brokerages have screening tools that can help you sift through various ESG (or sustainable/socially responsible/ethical) investments. Once you have a brokerage account, you can head to the next step.

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B. I want help with ESG investing

Building an investment portfolio takes time, especially when you are trying to find investments that align with a particular framework, such as ESG. Robo-advisors can make this easier. Robo-advisors are digital advisors that build and manage investment portfolios based on your risk tolerance and goals. They’re usually much less expensive than in-person advisors. And now more than ever, robo-advisors are jumping on the ESG bandwagon — often letting investors opt into a sustainable portfolio for no extra charge.

Here are some robo-advisors that offer socially responsible portfolios:

  • Betterment: Provides three impact portfolios to choose from: Broad Impact, Climate Impact and Social Impact.

  • Wealthfront: Offers a pre-made socially responsible portfolio. You can customize any portfolio with socially responsible ETFs.

  • Merrill Edge Guided Investing: Clients can invest in an ESG portfolio and request restrictions on certain ETFs.

» ESG for no extra fee? Explore robo-advisors with socially responsible portfolios

Just remember to investigate a potential robo-advisor’s methodology to make sure they use both inclusionary and exclusionary filters if you decide that’s important to you. If you choose to work with a robo-advisor, you won’t need to follow the rest of the steps.

2. Know your own ESG criteria

ESG has some pretty clear boundaries, especially in comparison to “ethical investing” or “socially responsible investing,” but that doesn’t mean it fits perfectly with your beliefs. Values differ from person to person, so take a little time to identify some of the values most important to you, and see if any fall outside of what “ESG” entails. If they do, make sure you’re looking for investments that also incorporate those ideals. For example, Muslim investors may want to ensure that their investments comply with Islamic law.

» Is sustainability just a label? Learn about greenwashing

3. Choose ESG investments

Once you have a brokerage account and you know what industries you want to support with your investment dollars, you can start creating your portfolio.

Reading reviews from independent research firms such as Morningstar can show you how a company or fund scores in terms of ESG investing factors, and whether you’d like to invest in them.

When you’re creating your own ESG portfolio, you’ll likely include funds such as ESG mutual funds or exchange-traded funds or ESG stocks.

Frequently asked questions

How is ESG calculated?

ESG scores are calculated by several different companies using varying methodologies, meaning there is no one authority on ESG scores. Most providers outline specific ESG indicators, such as climate change effect and political contributions, but those indicators often differ depending on the provider.

The way providers acquire their data differs as well. For example, MSCI ESG Research, one of the largest independent providers of ESG ratings, uses data that is collected from both company disclosures and government, academic and NGO databases. The Dow Jones Sustainability Index uses an industry-specific questionnaire to gather self-reported data from participating companies.

What are ESG companies?

ESG companies are those graded using ESG criteria — though if you’re looking for ESG companies to invest in, you’ll likely want those with the highest scores. You can use a stock screener to figure out a stock’s ESG score. Many providers break the scores down and show you a company’s performance in each category: environmental, social and governance.

» E is for environmental. Check out our list of renewable energy stocks

What are the best ESG funds?

Since ESG investors will look for more than just performance in their investments, and because the best fund for one person’s portfolio may be different for someone else, there is no one “best” fund. For example, a fund full of wind energy investments may not be ideal for someone who already has a good representation of wind energy companies in their portfolio. Instead, look for funds that match your personal values and would be a strong addition to your portfolio. Our list of ESG funds can help you narrow down the number of funds that may be right for you. Here are a few funds from that list:

  • 1919 Socially Responsive Balanced A (SSIAX)

  • Pax Large Cap Fund Institutional (PXLIX)

  • Thornburg Better World International I (TBWIX)

  • Parnassus Core Equity Investor (PRBLX)

  • iShares MSCI USA ESG Select ETF (SUSA)

I'm an enthusiast and expert in sustainable investing, particularly focusing on ESG (Environmental, Social, and Governance) criteria. My knowledge stems from years of researching and practicing sustainable investment strategies, analyzing market trends, and staying updated with industry developments.

When discussing ESG, it's essential to understand its core components:

  1. Environmental Factors: These aspects pertain to a company's impact on the natural world. This includes considerations like carbon emissions, air and water pollution, deforestation, green energy initiatives, waste management, and water usage.

  2. Social Factors: Social considerations evaluate how a company interacts with people, both within and outside its operations. Key areas include employee gender and diversity, data security, customer satisfaction, company policies regarding sexual harassment, human rights practices domestically and internationally.

  3. Governance Factors: Governance factors examine how a company is managed and overseen. This encompasses diversity among board members, political contributions, executive pay structures, management of large-scale lawsuits, internal corruption prevention measures, and lobbying activities.

Sustainable investing, particularly ESG investing, has gained significant traction in recent years due to its potential benefits:

  • Potential for High Returns: Studies, such as those conducted by the Morgan Stanley Institute for Sustainable Investing, indicate that sustainable funds have comparable or superior returns to traditional funds over certain periods.

  • Lower Risk: Research suggests that sustainable funds exhibit lower downside risk compared to traditional funds, especially during turbulent market conditions.

  • Alignment with Values: ESG investing allows investors to align their financial goals with their ethical and social values, promoting positive change while seeking financial returns.

It's crucial to distinguish ESG investing from other related concepts:

  • Socially Responsible Investing (SRI): While similar to ESG, SRI historically focused on excluding morally objectionable industries. ESG encompasses broader sustainability considerations.

  • Corporate Social Responsibility (CSR): CSR refers to a company's efforts to contribute positively to society, often intersecting with ESG principles but focusing on corporate behavior rather than investment strategies.

ESG investing offers various avenues for investors:

  • ESG Funds: These include mutual funds and exchange-traded funds (ETFs) that incorporate ESG criteria into their investment strategies. Examples include the 1919 Socially Responsive Balanced A (SSIAX), Pax Large Cap Fund Institutional (PXLIX), and iShares MSCI USA ESG Select ETF (SUSA).

  • ESG Stocks: Investors can also directly invest in individual stocks with high ESG scores, considering factors such as the company's environmental impact, social policies, and governance practices.

To embark on ESG investing, investors can follow these steps:

  1. Choose Your Approach: Decide whether to build your own ESG portfolio or seek assistance from robo-advisors specializing in sustainable investing.

  2. Define Your Criteria: Understand your values and preferences regarding ESG factors to guide your investment decisions effectively.

  3. Select Investments: Research and select ESG funds or stocks that align with your criteria and financial objectives.

ESG scores and evaluations vary among providers, emphasizing the importance of conducting thorough research and due diligence when selecting investments.

In conclusion, ESG investing offers a pathway for investors to drive positive change while pursuing financial growth, reflecting a growing emphasis on sustainability and responsible investment practices in the global financial landscape.

ESG for Beginners: Environmental, Social and Governance Investing - NerdWallet (2024)
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