With the growing popularity of ethical investing, ESG, which stands for ‘Environmental, Social, and Governance’, has become a hot topic in the financial world. But what does it mean exactly? Here’s a short guide to help you understand how ESG works and why it matters to investors.
What does ESG mean?
So what is ESG? ESG is a list of criteria used by investment professionals, also known as fund managers, to measure the ethical impact of companies that they choose to include within their ethical funds – think of them as hampers full of ethical investments. Put simply, before investing in any companies, fund managers will look at a wide range of factors that encompass the three key pillars of ESG: environment, society, and governance. They’ll check things like how much waste a company produces, how much energy it uses, what it does to champion gender and race equality, whether it gives back to local communities, what rights it gives it shareholders, and how transparent it is when it’s reporting to the public. Fund managers will then give an ESG rating to each company they examine. The better a company’s ethical standards are, the higher its ESG score will be and the more likely it’ll be to join the fund. But it’s not just ‘best-of-breed’ companies that are selected. Organisations that are working hard to improve their practices will also be considered by fund managers. Once they’re included in the fund, companies will be actively monitored to ensure their ethical standards are maintained. And if the ESG rating of a company falls dramatically, fund managers will remove it from the fund.
When it comes to ethical investing, there are two types of investment funds that can be built: active and passive ethical funds. At Wealthify, we’re using actively managed funds as we believe it’s the only way to build plans that are truly ethical. By investing in active ethical funds, you typically get someone who will conduct thorough research and due diligence to ensure the sustainability of your investments. Active fund managers also have the power to drive positive change. If they own a reasonable share of the company, they can use their shareholder voting power to influence how the organisation does business. Passive ethical funds, on the other hand, are cheaper than active funds, but they offer less flexibility as they use a fixed ESG score to screen companies and are unable to exert their shareholder voting power to make a difference.
Why ESG matters to investors
ESG matters because it gives investors the tools to build plans that reflect their principles, but more importantly, ESG can help push for change. Thanks to ESG, companies are held accountable for their actions and are urged to do better. Increasingly, businesses understand that they have to actively find ways to increase their positive contribution to the environment and society, or they might miss out on financing opportunities if they continue to ignore such issues.
But ESG isn’t just about values, it’s also about value. It’s often assumed that ethical investing has a negative impact on performance and returns. But research has shown that ethical investments tend to perform as well as other types of investments. Take the FTSE All Share, which lists over 600 UK companies, and the FTSE4Good that solely focuses on ethical UK companies. In the 5 years leading up until the end of November 2021, the FTSE All Share returned 30.56%, compared to a 30.69% return for the FTSE4Good1. In other words, you don’t necessarily need to compromise on potential returns if you decide to open an Ethical Investment Plan or an Ethical Stocks and Shares ISA. One thing to keep in mind though is that ethical investments can come with higher fees and charges, especially when they’re actively managed. So, before you enter the ethical world, make sure you’re happy paying a bit more to invest in line with your values and do your bit for the future.
1: Data from Bloomberg
The tax treatment depends on your individual circumstances and may be subject to change in the future.
Past performance is not an indication of future performance.
Please remember the value of your investments can go down as well as up, and you could get back less than invested.
