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The popularity of ESG investing continues to rise. There are a few reasons why, and they go beyond just goodwill.
ESG investing – investing in companies that meet certain environmental, social and governance requirements – has recently ballooned in popularity. More businesses are facing public pressure to lower their impact on the Earth, be perceived as treating their workers well and employ more transparent, shareholder-friendly practices.
Investors poured a net $46 billion into "global and sustainable" funds during the first quarter, while pulling a net $385 billion from stock funds overall, according to Morningstar. The investment research company tracks nearly 3,300 open-end and exchange-traded funds globally that use ESG criteria as part of their stock selection process.
As the pandemic sent the stock market into shock, stock funds of all stripes saw losses – but the global sustainable funds didn't take as large a hit.
Morningstar, which places sustainable funds into standard categories alongside comparable conventional funds, found that the returns of 70% of sustainable equity funds in the U.S. ranked in the top half of their categories for the first quarter of 2020.
While it would be nice to think that the strength of environmental and sustainable funds is due to the goodwill of investors alone, there are several reasons that these funds had a leg up.
Why sustainable funds lead
Sustainable funds tend to avoid sectors that were hurt by the virus spread. The funds were helped by having a smaller exposure to energy stocks than market indexes as energy stocks fell more than any other sector during the quarter, according to Jon Hale, Morningstar’s head of sustainability research.
The funds are also generally overweight in information technology stocks, which was the first quarter’s best-performing sector and have been doing well for years. Technology companies score high in ESG-compliance as they don't tend to be associated with issues like big carbon footprints (although with their controversies around fact-checking and privacy, many people might not actually see these companies as all that virtuous).
Of course, investors buy ESG funds for different reasons. Some investors are buying ESG-compliant stocks because the companies are perceived environmental or social good, while others are buying because they believe it's a smart business strategy, says Lauren Smart, global head of ESG Commercial at S&P Global Market Intelligence.
“There are plenty of investors who wouldn’t consider themselves to be impact investors but they don't want to be overly exposed to fossil fuels right now because they just don’t think it’s a growth part of the economy,” Smart says.
In the same way, some ESG investors want to own companies that have vegan options for environmental reasons, while others do so because social trends show there’s a demand for vegan-based products, or because the companies might have a bigger market among millennials, she adds.
Much of the criteria companies need to meet to be considered ESG-compliant is about managing risk – something that has been top of mind for businesses during the pandemic. “You would expect the company that has very good measures in place to manage risks across its people – its suppliers, its customer base, its operations – that they would do better, that they would be more resilient, because they’re better-managed companies,” Smart says.
How to Pick ESG Funds
When investing in ESG funds, it’s important do your homework — just like with any other type of investment.
Anytime you're looking to invest, you should make sure that you have a well-diversified portfolio that matches your risk tolerance, says Mike Kerins, founder and CEO of RobustWealth. When looking at ESG funds, choose those that match your risk tolerance, he adds.
To judge a funds financial profile, start at a site like Morningstar where you can see how it performed over various time periods such as three-, five- and 10-years relative to peers. You can also see its expense ratio, essentially how much it charges investors in management fees, and stewardship grade, Morningstar's attempt to gauge whether a fund's management is acting in the best interests of shareholders.
As for judging whether a fund's ESG credentials align with your values, you're the best person to do that. It's important to carefully read how an ESG fund selects stocks so you don't invest in a fund that only appears to be supporting issues that are important to you.
Most funds have the ins and outs of their stock selections available online, Kerins says, which you can read through to ensure that your investment aligns with your social or environmental values. The LGBTQ100 ESG Index, for example, has several steps in its methodology, including a survey from The Harris Poll of LGBTQ self-identified adults across the U.S. about their attitudes and behaviors toward companies and issues critical to the LGBTQ community.
By doing your research, you can get a little more insight into how ESG funds are looking to support various causes.
“You should be able to invest with your values,” Kerins says. “Whatever they are.”