Are you intrigued by the idea of investing with a purpose—simultaneously growing your personal wealth while supporting social and environmental causes? If so, you’re not alone. For the past few years, the concept has been steadily gathering steam among individual investors of all ages.
If you’re just starting to investigate this investment approach (which includes socially responsible investing and its variants—impact and ESG investing), you might be wondering about the reasons behind its appeal and if there are any downsides to it.
In short, socially responsible investing is possible, but it’s not a completely cut and dried investment strategy. In this article, we’ll cover the basics of socially responsible investing and its ESG variant, the pros and cons, and some tips to keep in mind should you decide to allocate assets in this way.
Need help formulating an investment approach that aligns with your values? Schedule a call with us at Bay Point Wealth to talk about your goals.
ESG Vs. SRI Investing
Environmental, social, and governance (ESG) investing and socially responsible investing (SRI) can be viable strategies to grow your wealth in a way that aligns with your personal values. Before you get started with either approach, it’s important to understand the difference between ESG vs. SRI investing, so you can decide whether either is a fit for your specific financial plan and goals.
ESG Investing At A Glance
ESG investing attempts to screen or rank companies from all available investment options based on quantifiable metrics on their environmental impact, commitment to social responsibility, and governance practices. The form of screening can be inclusive—known as a “positive screen” for companies that perform well in these three categories—or exclusive, where companies that do not meet certain thresholds are excluded entirely.
There is no single screening methodology for ESG funds; however, there are common practices. For example, when evaluating a company’s eligibility for an ESG fund, an ESG consulting group may consider the efforts the company is undertaking to reduce its environmental footprint.
While it’s not a new investment strategy, ESG has been top of mind for many investors in recent years as environmental and social issues dominate news cycles around the world. Global ESG investments are expected to more than quadruple from $11.35 trillion in 2012 to a projected $50 trillion by 2025.
“At their current growth rate, ESG-mandated assets…are on track to represent half of all professionally managed assets globally by 2024,” according to Deloitte.
SRI Investing At A Glance
In contrast to ESG investing, traditional socially responsible investing exclusively screens or eliminates companies out of the pool of eligible investment options based on more subjective criteria or wide-ranging, generally accepted values.
The major difference between SRI and ESG investing is the singular focus on social responsibility whereas ESG is broader in scope, making considerations for environmental impact and corporate governance. This use of a negative screen is another difference when choosing socially responsible investing vs. ESG.
Socially responsible investing can be a highly personal strategy, as long as you are clear on your priorities and objectives. For example, you may choose to eliminate companies involved in the gambling sector from your portfolio if you disagree with the mandates of these organizations from a moral standpoint.
Finally, similar to ESG investing, socially responsible investing is on the rise. This trend is not surprising, in light of the fact that 75% of Americans say it’s unacceptable for companies to only make money; they must also have a positive impact on the world.
“Results of a 2021 survey by investment firm Natixis showed that millennial Americans, now in their late 20s through early 40s, are twice as likely as the general investor population to focus on SRI investments,” according to Investopedia.
Pros And Cons Of Socially Responsible Investing
Benefits of socially responsible investing include...
It used to be that you had to sacrifice investment returns in order to invest this way. Today, it’s no longer the case that your portfolio has to suffer. One analysis revealed that six out of 10 sustainability-focused funds delivered higher returns than equivalent conventional funds over the past decade; another study showed that similar funds strongly outperformed the competition in early 2020, when the COVID pandemic hit.
However, keep in mind that the stock market as a whole is already pricing in many investor expectations related to social and environmental issues. If current market expectations undervalue the importance and economic impact of these issues,over time, markets may reward the companies that have prioritized these causes, and vice versa. So, to design a portfolio that attempts to focus more on these elements may not be necessary for every investor, since SRI and ESG criteria are not specifically designed to optimize returns based on financial criteria alone.
Dual Rewards: Profit & Purpose
While you could always avoid investing in companies that are contrary to your values, you can now identify groups of companies that align with your passions and actively support them. The idea of “doing well by doing good” appeals to many people who feel strongly about particular causes.
Arguments against socially responsible investing include...
Challenges In Selecting The Right Funds
Since there is no single definition of what constitutes a so-called “socially responsible company,” there are plenty of ways to rate and rank these organizations. ESG investors may find conflicting ratings on companies provided by different ratings agencies. Efforts are underway to try to bring more standardization to the industry, but until then, it’s helpful to enlist a financial advisor to identify and analyze the funds that best align with your goals.
Higher Management Fees
A common argument is that fund managers tend to charge more in fees than they would for conventional funds, which can negate higher returns. These higher fees are due to the fact that identifying companies that are a good fit for a particular portfolio requires more research and special screens. Now, thanks to greater investor demand, there are more analysts who specialize in this area and more ESG-related information available from companies, which has brought the price down.
ESG Vs. SRI Investing: Important Considerations
Now, let’s walk through seven essential points surrounding ESG and SRI investing to consider when creating your investment portfolio, whether on your own or with your financial advisor.
1. Know the difference between ESG, SRI, and impact investing.
Potential investors often confuse ESG, SRI, and impact investing, but you’re not likely to find companies that are specifically focused on the environment in an SRI portfolio. There can be some overlap because, by eliminating companies such as weapons manufacturers, you may reduce the carbon footprint of your portfolio. However, SRI is generally geared toward companies with certain moral or social values.
2. Choose SRI investing to screen out specific industries and/or company types.
With ESG investing, you can’t screen out particular sectors or company types. As a result, you could potentially find an adult entertainment company in an ESG fund if the business was making a positive contribution to the environment. When pursuing socially responsible investing, know that the more restrictive you want to be with your investments, the more concentrated your portfolio will become, potentially introducing risk.
3. Exercise due diligence with your investment choices.
Due diligence is always necessary with your investments, but it’s especially so if you're considering SRI or ESG. It’s common to hear about fund companies rolling out high-cost products that are “greenwashed” (i.e., falsely conveyed as being environmentally responsible investment choices). So, you need to ask questions that you wouldn’t necessarily have to ask in an evaluation of non-SRI or non-ESG funds. For example, if you’re looking at a mutual fund that claims to be environmentally responsible, you must ask how the fund companies are achieving that objective.
4. Consider your existing investments.
Before adding new companies to your portfolio, think about how your ESG investment would fit in. Be sure you're not overinvesting in a particular industry or asset class, and rather than investing in individual companies, we recommend ESG mutual funds. They are naturally diverse, and all holdings have been vetted by experts who are not only skilled at screening but also understand what makes a solid investment.
5. Understand your potential for returns.
ESG investing has become more accessible in recent years, and the number of funds available has increased, which means returns have improved as well. This investment strategy may be an ideal fit if you are primarily concerned with returns rather than screening out specific industries or companies you do not support. However, keep in mind that if you wish to implement an investment strategy that excludes fossil fuels, that may come with a tradeoff in terms of returns and diversification.
6. Always invest based on your risk tolerance level and cash needs.
You must assess your propensity for risk before implementing any strategy in your portfolio. Everyone has a different comfort level for investing, and the types of funds that are right for you will depend partly on your ability to tolerate volatility in the stock market. Your investment strategy should also consider your short term cash needs. If you’re able to keep your money invested for several decades as opposed to just a few years, you’ll have the opportunity to invest more aggressively if you wish.
7. Review the fund periodically to see if your investment is making a difference.
To see if your fund is actually having as positive of a societal impact as you expect, ask to see the aptly-named impact report. Impact reports cover topics like shareholder engagement, carbon footprint, and gender diversity on the Boards of the companies included in your fund—all of which allow you to evaluate the impact you’re having as an investor.
Looking for expert investment guidance?
ESG and SRI are both solid strategies for investors who want to grow their wealth in a way that aligns with their personal values. The key point to remember about these strategies (and any others) is to execute them with your end objective in mind. At Bay Point Wealth, we take a goals-based approach to financial planning, and we consider your complete financial picture before we recommend a course of action.
If you’re interested in discussing an investment strategy to help you reach your future objectives, schedule a call with us today to get started.