July 2023
ESG is an abbreviation for environmental, social and governance. Investing in ESG refers to investment strategies that attempt to match up financial returns with corporate social responsibility. The goal is to allow investors to align their values with their investment choices. The premise that companies can be just as profitable while adhering to ESG principles has gained widespread, but by no means unanimous acceptance in recent years. Come to think about it, what idea or principle ever gets unanimous acceptance? Maybe apple pie.
An investment identified as ESG may focus on one or more of these initiatives:
Environmental: This aspect examines how a company contributes to the planet's well-being. It includes efforts to reduce greenhouse gas emissions, promote renewable energy and conserve natural resources.
Social: The social component examines how an organization treats its employees, customers, suppliers and local communities. Factors considered include labor standards, racial diversity, inclusivity and support for human rights.
Governance: Governance refers to how a company is managed, including administrating shareholder rights, executive compensation and communication with shareholders. Key principles include aligning executive pay with performance, ensuring accountability and promoting transparency.
While supporting socially responsible practices seems appealing, there are drawbacks to consider. One primary concern is the lack of standardized criteria for evaluating ESG performance, leading to unreliable data. Metrics used to determine whether a business is genuinely ESG-worthy are often subjective, which has raised skepticism about the credibility of some ESG investment funds. Furthermore, a wide range of opinions on what constitutes social good makes it challenging to establish a universally accepted framework.
For example, regarding energy sources, some argue that nuclear power is clean and efficient, while others raise concerns about safety and waste disposal. Similarly, opinions vary on carbon capture and storage as a means to combat climate change and the use of fossil fuels. Additionally, some funds choose not to invest in specific industries, such as alcohol. However, others would say that alcohol consumption in moderation is safe and enjoyable.
Despite these challenges, it is generally recommended, with careful review and research, to include ESG funds in investment portfolios. Many ESG funds have shown excellent past returns, indicating that their strategies have not negatively impacted shareholders. When adding any investment to a portfolio, it is crucial to consider the overall asset mix, industry sectors, international exposure and investment types.
The Parnassus Core Equity fund, in operation since 1992, has an annual return of 11.4% for the last fifteen years. Vanguard’s FTSE Social Index fund opened in 2003 is at 11.6%. The S&P over the same 15 years is 11%.
It's important to note that funds not categorized as ESG can still invest in companies with positive social attributes. Various sources, such as Morningstar, provide good social attribute ratings for mutual funds that are not explicitly defined as ESG. Another option for investors is to invest in specific companies. However, mutual funds offer the advantage of diversification across multiple companies, thereby reducing risk.
Some folks don’t see climate warming as a problem. I’d hate to be the one to try to explain that to the residents of Death Valley.
Surprisingly, ESG investing is viewed differently by Democrats and Republicans. Through the Department of Labor the Trump administration issued regulations intended to restrict ESG investment offerings in 401k’s. The Biden has reversed them. 401k’s are covered under federal ERISA regulations, which requires employers to have the components of their retirement plans be in the best interest of the plan participants.