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What is Environmental, Social & Governance (ESG) & Why it Matters

Sustainable investing has come a long way from what was previously called socially responsible investing. There are smart new strategies and tools that are uncovering many new investment opportunities.

Many people haven’t kept up with all the ways that sustainable investing has changed. They still assume that sustainable investing only focuses on environmental factors, when, in fact, sustainable investing covers a wide range of important issues that are grouped into three broad categories: environmental, social and governance (ESG).

Understanding ESG

E is for Environmental

Environmental issues are perhaps the most widely understood. They consider a company’s impact on the planet. A company with strong environmental practices uses renewable energy; reduces emissions; supports clean air and water; and works to address the risks of climate change.

S is for Social

Social issues are based on how a company affects people, including its employees and customers. A socially responsible company treats its workers fairly, provides a productive workplace, keeps customer data secure and creates good products that are safe to use.

G is for corporate governance

Governance is about how a company runs its business. A company with good governance works to balance the needs of executives and shareholders. It has a diverse and independent board of directors. It’s open about its political and lobbying efforts, and it has policies in place to prevent bribery or corruption.

Why ESG matters

1. ESG can help you align your investments with your values

A company’s environmental, social and governance (ESG) policies help investors determine which companies they want to support.

2. ESG can help you invest in good businesses

Many companies are finding that ESG practices can also be good for business. A company can save money by using renewable energy and it could gain customers by producing safe products. A company with strong oversight from its board may operate more efficiently or avoid costly lawsuits or fines.

3. ESG may help your returns

Studies have repeatedly found that companies with good ESG policies also have performed well. A 2015 review1 of more than 2,200 studies since the 1970s found a positive link between ESG factors and good financial performance.

How to find good ESG investments

Many funds seek to own companies with strong ESG practices, and new fund ESG ratings from Morningstar and MSCI have substantially expanded the number of funds to choose from. A 2016 MSCI study2 found that thousands of funds had “significant exposure to sustainable impact themes”, but only 14% of these funds were self-professed ESG or sustainable funds.

How you use ESG ratings really matters

Funds with terrific ESG ratings aren’t always the best performers, so if you only use ESG scores to select funds, you may not get the returns you need to fund a comfortable life in retirement.

Since ESG ratings are based on a fund’s portfolio and not on any one particular stock, you may find that some funds with high ESG ratings own companies that you don’t want to support, or these funds may not focus on the issues that are most important to you.

ESG ratings also change as the funds’ portfolio changes, so you may need to check on your funds more often to make sure they’re still up to your standards.

In the sustainable investing portfolios we manage, we monitor a fund’s performance and ratings regularly to keep you invested in a way that we believe has the potential to build wealth and build a better world.

Gunnar Friede, Timo Busch & Alexander Bassen, “ESG and financial performance: aggregated evidence from more than 2000 empirical studies”, Journal of Sustainable Finance & Investment, 2015.

MSCI Research, Inc., “Fund Transparency: Exploring the ESG Quality of Fund Holdings.” March 2016