What is ESG and why does it matter to my investments?

“ESG” sounds like something very technical and jargon-y.

In fact, it’s an increasingly popular investment approach that takes into account Environmental, Social and Governance factors - not just financial factors - when assessing whether to buy shares in a company.

Considering a company’s environmental and social impact as well as how well the company is run (governance can include things like executive pay, frequency of reporting, transparency, etc) is not just something that’s nice to do. It’s actually financially material, too.

Studies, including the weighty Barclays Equity Gilt Study, have shown that funds that have adopted what’s called an ESG approach actually outperform other funds over the long run.

Funds that have adopted what’s called an ESG approach actually outperform other funds over the long run

That’s because, while they might not score as highly for short-term profitability as some other companies driving hard for profit at all costs, they are less prone to costly errors that can bring the share prices of more cavalier companies crashing back down as quickly as they went up. They are also less vulnerable to regulation that is designed to support environmental or social goals, or to curb poor corporate practice, such as tax evasion.

As more countries legislate to meet globally beneficial aims such as CO2 reductions, should investors be seeking funds, stocks and shares that score highly for ESG, rather than those that do not take such risks into account?

The short answer is yes. Particularly if you are investing for the long term, for goals such as your retirement, or your children’s university education.

An ESG-themed approach will not only help shield your portfolio from shock losses caused by scandals or new national or global regulation, it will also help boost your returns over the years.

The good news is more and more funds are adopting an ESG approach - even those that are not labelled as such - because the evidence that it is beneficial is now so hard to refute. So there is more to choose from than ever and more opportunity to profit from doing good.

John Fleetwood, of 3D Investing, has identified more than 200 funds in the UK that are labelled as ethical or sustainable - this is not quite the same as ESG, which is an even broader range, but goes to show that choosing such an approach does not narrow down your choices as an investor.

But some funds that proclaim an ESG approach are better at it than others. One way to tell apart those that are taking ESG seriously and those that are not is to check out Morningstar sustainability ratings, which you will find on a fund’s factsheet.

The strange thing is that oil and gas companies can still appear to do relatively well on an ESG basis

These use Sustainalytics data and assess a variety of ESG factors including preparedness, disclosure and performance, relative to other companies in the peer group.

A good method, if you are considering an ESG approach, is to avoid those funds that do not have any rating at all and to only choose those that are rated 3 stars or above by Morningstar.

However the Morningstar ratings method is still fallable, particularly for those that would rather exclude whole sectors, such as oil and gas, because of their vulnerability to environmental legislation - the strange thing is that oil and gas companies can still appear to do relatively well on an ESG basis, so long as they make improvements based on the year before and score well relative to peers. Yet this sector is one that does present an ESG risk. There’s oil spills, but there is also the risk that because of legislation to cut CO2 emissions, much of the oil still left underground will have to stay there - a risk to oil companies that organisations such as Carbon Tracker believe has not been priced in. This is a big deal, because oil and gas companies such as Shell and BP make up such a significant proportion of the FTSE 100 and are responsible for paying the dividends that support millions of pension pots.

So if you are quite sure that you don’t want to invest in certain things, a positive impact, rather than an ESG approach, might be more appropriate for you. This refers to when fund managers invest only in companies that are coming up with solutions to world problems, such as food or water shortages, energy efficiency needs and the switch to electric vehicles. By default, these funds do not invest in areas where legislation is likely to be detrimental.