Taking a look at ESG investing

May 26, 2023

Q: I have been hearing more and more about ESG investing. Some people say it produces better returns. Do you think it makes sense? If so, how is the best way to get exposure to ESG?

A: ESG investing is an investment selection process that considers environmental, social, and governance factors (hence the name ESG) in addition to more traditional financial analysis. In the past, this type of investing has also been called “sustainable investing” and “socially responsible investing,” or SRI. The main effort of ESG investing is to take into account the effects of an investment on people and the planet at large.

Environmental considerations involve thinking about how a business affects the world around us. Analysis of the company's environmental performance includes looking at its carbon footprint, waste management policies, and other environmental impacts.

Social considerations relate to how a business treats its workers, customers, suppliers, and local communities. Social considerations include looking at things like working conditions, human rights, policies promoting diversity and inclusion, safeguards for consumers, public participation, and more.

Governance refers to the way a company’s board of directors and management are organized and compensated, and how they behave. Analysis of governance involves checking on things like board diversity, executive pay, accountability, transparency, and ethical behavior. Responsible business operations are the result of good governance.

Various ESG investment strategies are available. One of the oldest, simplest, and most common strategies is called screening. With ESG screening, certain products or industries are excluded from the portfolio. For example, some religious organizations have long had investment policies that exclude so-called “sin stocks” (i.e., companies that engage in gambling, the production and distribution of alcohol or tobacco, etc.). Other ESG investors may screen out gun manufacturers, defense contractors, oil companies, or any other industry that they feel does not fit with their values.

Other common ESG strategies include best-in-class investing (targeting companies with best-in-class ESG performance within their industries), thematic investing (building portfolios focused on specific sustainability themes like clean energy or healthcare), and impact investing (seeking measurable social or environmental outcomes alongside financial returns). The California Public Employee Retirement System, also known as CalPERS, is one of the largest ESG investors in the world. It actively uses each of these strategies as it manages its portfolios valued at more than $450 billion.

Some of its more ardent proponents believe ESG investing leads to better long-term performance. Unfortunately, I don’t think we have enough history to support such a claim. Instead, we are probably better off thinking of ESG investing as a way to align our investment behavior with our values. Any outperformance would be a welcome windfall; any underperformance ought to be thought of as the price of living our values. In any case, it is wise to consider the potential costs before moving into an ESG portfolio.

Several years ago, a client came to me with concerns about her portfolio. She had just watched a documentary on the evils of Big Oil and she wanted to divest her portfolio of any and all oil stocks. I told her I understood completely and that we would do whatever she felt was necessary. As we discussed the idea in detail, she came to understand that selling her oil stocks would generate large capital gains taxes since she had owned the stocks for a while (she had inherited the shares many years before from her father). She also realized that her oil stocks paid a very attractive dividend—two or three times higher than most other blue-chip stocks. It was a double whammy. Not only would capital gains taxes reduce the size of her investment portfolio, but the lower dividends on the replacement stocks meant the new smaller portfolio would produce a lot less income. After looking at the numbers for a few minutes, she said, “On second thought, let’s keep the oil stocks. I’ll find other ways to fight Big Oil.”


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Steven C. Merrell  MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., an independent wealth management firm in Monterey.   He welcomes questions you may have concerning investments, taxes, retirement, or estate planning.  Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA  93940 or email them to smerrell@montereypw.com.