ESG Investing: How to build an ethical portfolio that reflects your values

• ESG investing is a type of investing that considers the sustainability and societal impact of a company or business.
• ESG investments are rated on their environmental, social, and corporate governance impacts.
• Research suggests ESG investments are more lucrative and more stable than other traditional fund types.

In the past, if an investor wanted to put their money where their mouth was and invest in companies that aligned with their morals, the only option was to avoid certain companies or markets. But as impact investing has evolved and expanded, so have the opportunities for investors to build portfolios they truly believe in.

One such opportunity is ESG investing, a method of sustainable investing that doesn't just consider an asset's rate of return. It scores a company in three crucial areas pulled straight from the acronym - environmental, social, and corporate governance - to help investors build portfolios they can be proud of.

These socially conscious decisions are not only designed to be more ethical, but in some cases ESG investments have been shown to be less risky and more profitable as well. They're also customizable and are becoming more popular by the day, particularly as investing at large becomes more accessible.

What is ESG investing?

ESG investing is a form of socially responsible investing where ESG investors commit to supporting businesses and companies that align with their own views on sustainability and dedication to providing a positive societal impact. An institution's priorities could be anything from reducing carbon emissions, to providing community outreach initiatives, to tax transparency, which all fall under the umbrella of ESG investing.

Individual companies or assets are then rated on how well they adhere to the ESG guidelines. Each letter that makes up the ESG acronym stands for one of the three factors used to assess and rank a given investment.

• Environmental: Conservation efforts aimed at protecting the Earth and our natural environment, including emissions and air quality, waste management, land usage, and energy footprint.
• Social: A look at the company's connective tissues, including on-site labor practices, safety standards, community outreach, equal employment opportunities, and product quality.
• Governance: A snapshot of the standards that leadership is held to, including ethical business practices, board diversity, executive compensation vs. employee pay, and overall transparency.

Despite all these bars to clear, ESG funds are just as lucrative as traditional funds. A 2020 Morningstar study found that in 2019, ESG funds outperformed conventional funds, with many matching or surpassing the S&P 500 as well.

ESG funds are also lower risk compared to other market offerings. The Morgan Stanley Institute for Sustainable Investing released a white paper in 2019, comparing the performance of traditional funds and sustainable funds between 2004 and 2018. It found that the latter had significantly decreased downside risk, a measure of how the asset performs in worst-case scenarios, like times of turbulence and volatility.

The paper also found that on average, sustainable funds experienced a 20% smaller downside deviation - which is a measure of risk and price volatility - than conventional funds. According to a 2016 study in the Journal of Sustainable Finance & Investment, this could be attributed to reduced vulnerability to "reputation, political and regulatory risk," which in turn leads to a more stable cash flow and increased profitability.

Across the board, current data suggests that ESG funds are as compelling for their long-term stability and market returns as they are for their merit on more moral and ethical grounds.

Why does ESG investing matter?

While the term wasn't coined until the 2000s, the practice of ESG investing stretches back much further. It began with religious groups such as Muslims, Quakers, and Methodists who avoid businesses dealing in alcohol, tobacco, and gambling, and want their portfolios to do the same.

ESG investing has been adopted by other groups looking to align their investments and their beliefs, from the Vietnam anti-war movement in the 1960s and 1970s, to a call for corporate accountability in the '80s, and climate change initiatives in the 1990s.

Today, ESG investing is significant in that it allows the individual investor to engage with the market and the economy in small but marked ways, aligning with businesses that share their values, a process known as conscious capitalism.

As the practice spreads, and ESG investing is utilized by increasingly larger groups, it allows socially conscious investors to put pressure on corporations from the inside via shareholder activism - using their influence as partial owners to encourage businesses toward a brighter, more sustainable future.

In the news: In March 2021, the SEC announced the creation of a task force focused on climate and other ESG issues and accountability standards. The initiative comes as companies are setting their own ESG goals, in a larger push to define ESG.

ESG investing vs. socially responsible investing

The terms ESG investing and socially responsible investing (SRI) are often used interchangeably in the investing space, and they do have a fair amount of overlap. For each strategy, investors make decisions based on social impact instead of rates of return alone, and both represent ways of making your voice heard as a conscious investor.

It's in the method where the two factions diverge.

SRI relies on excluding problematic investments from your portfolio. If one of your passions is carceral reform, for example, and it's revealed that a successful company exploits prison labor for its profits, you would divest from that company no matter how high its profits soared.

With ESG investing, things are less black and white. The strategy is based on a rating system, and while higher-ranked investments are preferred, there's no rule that states you can't invest in a lower-ranked company - as long as it has stated goals for improvement. Because of this flexibility and potential for customization, investors often don't have to choose between their morals and their own bottom line, but can incorporate both considerations.

Finally, there's a third term at work: impact investing. In direct opposition to SRI, this method adopts an inclusionary technique, seeking out companies that work toward specific goals for social betterment, like eradicating world hunger or poverty.

Types of ESG investments

For those who want to explore some promising ESG investments, there are scores of highly rated options in each category. To give you an idea, here are a few worth exploring:

• Environmental ESG investments: iShares Global Clean Energy ETF (ICLN) - tracks the S&P Global Clean Energy Index, providing exposure to companies pursuing renewable resources
• Social ESG investments: Vanguard FTSE Social Index Fund Admiral (VFTAX) - an inexpensive option that works only with companies with clean labor and human rights records
• Corporate Governance ESG investments: iShares ESG MSCI USA ETF (ESGU) - subjects each of its investments to a corporate governance review.

Other market leaders that aren't specific to a certain category include:

• iShares MSCI USA ESG Select ETF (SUSA)
• Natixis Sustainable Future 2025 N (NSFEX)
• Shelton Green Alpha Fund (NEXTX)
• Vanguard ESG US Stock ETF (ESGV)
• Xtrackers MSCI USA ESG Leaders Equity ETF (USSG)

Finding ESG opportunities

You can find more ESG funds and follow current trends with resources like MSCI, a financial services company dedicated to corporate responsibility. There, you'll find an entire vertical stocked with the latest research on ESG investing, including data and ratings.

When it comes to ratings, no one method has yet been adopted industry-wide, but companies like Morningstar, MSCI, Bloomberg, and Sustainalytics are all popular data providers.

Morningstar's methodology is a tri-pronged equation that gives you a number between one and 100, rating the amount of ESG risk carried by that investment:

• 0-9.99: Negligible ESG Risk
• 10-19.99: Low ESG Risk
• 20-29.99: Medium ESG Risk
• 30-39.99: High ESG Risk
• 40+: Severe ESG Risk

There are also online trading programs you can use to find and build a portfolio based on ESG Investments, like BTheChange.com, which breaks investments into five categories: those best for the environment, community, governance, workers, and customers.

The financial takeaway

ESG investing is a sustainable approach to the market, which weighs an investment's impact in environmental, social, and corporate governance spheres more heavily than it does its profitability.

While some forms of socially conscious investing require a choice between returns and responsibility, ESG investing largely does not. Research has shown that investments with high environmental, social, and corporate governance ratings also tend to be more lucrative and stable.

ESG funds are also easily personalized to reflect the values of any given investor, making them an excellent choice for the socially conscious - inexperienced and sophisticated investors alike.