In 2005, the UN’s Secretary-General invited some of the world’s largest institutional investors to develop the Principles for Responsible Investment. These principles formed around the idea that environmental, social, and governance (ESG) issues affected how well investment portfolios did, so it was important to consider them alongside the usual financial factors. Since then, ESG and SRI (socially responsible investment) have become embedded into corporate and individual decisions around finances and investments. What are ESG and SRI exactly? And what’s the difference between them?
ESG is a series of objective criteria that evaluates investment options in environmental, social, and governance. While SRI technically falls under ESG, it’s a more specific, subjective method individual investors use to align their investments with their values.
What is ESG?
ESG stands for “environmental,” “social,” and “governance.” These are non-financial factors that affect the performance and sustainability of companies and stocks. A specific investment’s ESG score represents the investment’s sustainability in those areas. What do these categories include, exactly? Let’s take a closer look:
Environmental factors measure a company or stock’s impact and sustainability on the environment. That can include deforestation, waste management, water usage, green energy policies, greenhouse gas emissions, recycling policies, and so on.
The social factor looks at the impact on people, including those who work at the company, a company’s consumers, and anyone else affected by the company or stock’s existence. Metrics include a company’s policies on diversity, sexual harassment, the gender pay gap, and social justice. Data security, customer service, and the supply chain also fall under the “social” umbrella.
Governance includes things like a company’s political contributions, lobbying policies, executive pay, and the diversity of the board. A company/stock’s governance score is also affected by how transparent the company is with shareholders, internal corruption, lawsuits, and anything else related to oversight.
What are the different types of ESG investments?
If you’re interested in building a portfolio based on ESG, there are a few ways to go about it:
As more of the corporate world commits to ESG principles, it’s becoming easier to find companies with good ESG scores, as well as good returns. Some companies highlight their ESG accomplishments and goals through reports, while there are also websites that can help educate investors. How do you find ESG scores? An article on The Impact Investor lists providers that give good assessments of an investment’s ESG opportunities and risks. These providers look at factors like investment risk, financial strength, sustainability, and ESG. Examples include Sustainalytics (a subsidiary of Morningstar), which gives ESG ratings on 20,000 companies in 172 countries. Regulations for these providers vary; in the United States, ESG rating agencies aren’t officially regulated. As a piece from Harvard Business Review explains, ESG scores shouldn’t be the end-all-be-all for investors or companies. Real sustainability lies in concrete action and change.
ESG mutual funds
Mutual funds are professionally-managed portfolios with stocks, bonds, and other securities. They’re a great way for individual investors to diversify their investments. The law requires mutual funds to disclose their performance and fund activities. There are different categories within mutual funds, such as stock funds, which invest mostly in equity or stocks, and balanced funds, which invest in a mix of asset classes. As ESG becomes more popular, more ESG mutual funds have popped up. These are funds full of stocks and bonds evaluated with existing ESG criteria. Some funds have a special focus, like the environment, so you can choose which part of “ESG” you want to prioritize. If you’re interested in ESG mutual funds, you should first figure out how much you’ll need to pay in annual fees (called expense ratios). These are taken as a percentage of the investment.
ESG ETFs (exchange-traded funds)
Like mutual funds, ETFs include stocks, bonds, and other securities, but they’re traded on the stock exchanges. This means they can be bought and sold throughout the trading day, while mutual funds can only be bought or sold once during the day. As a result, the price of an ETF changes during the day while mutual funds are priced once daily. ETFs enjoy the benefits associated with stocks, along with lower fees and tax advantages. There are some downsides such as less options for diversification. According to reporting from The Motley Fool, both ESG mutual funds and ESG ETFs rose 53% to $2.7 trillion.
What is SRI?
SRI (socially responsible investing) is a strategy investors use to align their investments with their values. Unlike ESG, it’s not based on objective criteria. Individuals determine what values matter most to them – green energy, diversity on the board, ethical supply chains, etc – and eliminate companies and stocks that don’t adhere to those values. Here are some of the most common concerns for SRI adherents:
Many people embracing SRI care deeply about the environment and fighting climate change. When building their portfolios, they’ll try to reduce or eliminate all investments in gas and oil companies. This means excluding companies like ExxonMobil while including companies creating – and using – renewable energy.
Land use, pollution, and animal welfare
A company’s impact on land use, pollution, and animal welfare is closely tied to climate change, which is a big concern for many investors. They’ll closely examine a company’s history with land use, water and air pollution, and its impact on animals.
Social justice/human rights
Social justice and human rights are also important in SRI. Investors try to only invest in companies with strong DEI principles, regular donations to social causes, ethical practices regarding their workforce and supply chains, and so on. If a company is guilty of unethical practices and human rights violations, investors will avoid them or pull their investment.
What are the different types of SRI investments?
If you’re interested in SRI as an investment strategy, here are two types of investments you can consider:
Mutual funds and EFTs
As with ESG, you can embrace SRI by investing in mutual funds and EFTs. Because SRI is an individualized strategy, you’ll tailor your search based on the values that matter most to you. As an example, if you decide to focus on green energy, look for mutual funds and ETFs focused on that area. If you discover you’re investing in gas and oil companies, cut them from your portfolio and invest the money elsewhere.
Community investing is the support of investment products and institutions focused on disenfranchised communities. In the United States, Community Development Financial Institutions (CDFIs) specialize in lending to underserved individuals, businesses, and organizations. There are currently more than 1,300 certified CDFIs in the country, including community development banks and community development credit unions. These institutions provide services like personal credit, small business loans, home loans, and more. How do you invest in a CDFI? Most community development banks offer ways for investors to help the bank build capital while getting returns. It can be as simple as making a deposit with the bank.
Is ESG good for companies?
When companies commit to making environmental, social, and governance progress, it’s good for business. The November 2019 edition of McKinsey Quarterly explained how “strong ESG propositions” help companies grow and expand into new and existing markets. This is because ESG commitments and progress make corporations look good, so the authorities in charge of them are more likely to give them licenses and other access to markets. Companies also cut costs when they reduce their energy and water consumption; enjoy government support and subsidies related to ESG; and attract employees who want to work for ethical, sustainable companies. Strong ESG practices also attract consumers. Multiple studies show more and more consumers are starting to care about moral products (though what “moral” means can vary), so it’s in a company’s best interest to invest in ESG.
Is SRI good for investors?
Because SRI is based on specific, individual values, it’s an active process. Depending on your values, it may be tricky to find funds with an SRI strategy. As an example, if you care about gun control in the United States, you may have to dig deeper to find which companies are investing in guns than if you were primarily interested in green energy. Luckily, it’s become easier to identify and eliminate the companies investing in arms. If you’re using a manager, start by seeing what they’re investing in and whether they’re offering mutual funds or EFTs that are gun-free.
Is SRI a reliable way to make good returns? A 2020 report by the Morgan Stanley Institute for Sustainable Investing found that sustainable funds (which includes both ESG and SRI) did better by 4.3 percentage points than traditional funds during the pandemic. That represents the biggest recorded difference in performance since 2004. Things got worse in the stock market toward the end of 2022, but in an especially rough year, ESG funds weren’t too different from their counterparts. The reason they did worse is clear: energy, which Chevron and ExxonMobil still rule over and which many ESG funds avoid, was the only sector (of 11) in the S&P’s 500 stock index to go up in 2022. As the energy sector evolves and hopefully becomes greener, ESG and SRI investors can put money into that sector and start seeing better returns again.