ESG Investing: A Short Discussion

ESG (Environmental, Social and Governance) principles have gained increased recognition and momentum in the last decade. A number of companies, funds and indices claim to follow the ESG norm. While in theory ESG implementation seems perfect, in practice however, there are a number of challenges when it comes to evaluating and benchmarking ESG and its implementation. A lot of research is being conducted to mitigate the ESG challenges. For example, some believe that ESG-based investments do not beat the market benchmark returns and can in fact be lower than the benchmark return. On the other hand, some argue that ESG investments will outperform in the long-run and not focus on short term return. Every study is based on its unique assumptions and calculations.

As retail investors, we are probably okay with market benchmark returns if we are investing from long-term perspective. However, when selecting an ESG investment, we ought to know: (1) how impactful and truthful are the companies that claim they follow ESG principles, and (2) how has the fund / index evaluated that the portfolio companies truly have an ESG impact. This is mainly because there is no consensus on ESG reporting norm and the fact that every fund / index has its own framework. As retail investors, we do not know how reliable these frameworks are. So what can we do to contribute and promote ESG despite its challenges?

Well, one of the straightforward answers is that we diversify our holdings outside of ESG – in say, utilities or tech which may not be excessively following ESG principles but are also not extremely harmful to the society and environment. However, one will think at this point, will this diversification be able to bring change? It is possible that this ambiguity may be harming the prospects of truly good ESG companies and funds. As a retail investor, we are also restricted in transitioning excessively towards ESG investments. Also, it is not in our capacity to change the way an ESG fund is structured. Hence, a retail investor can generally only support from a back seat. Only rarely a retail investor can have an activist impact (not denying its possibility).

We must understand that ESG investments in themselves are not bad regardless of their sub-par returns compared to conventional funds. In fact, it could be possible, some ESG funds may be generating abnormal returns (returns over and above the market index / benchmark). Hence, returns should not be our only radar.

One way we could diversify is by allocating half of our savings in ESG ETFs / mutual funds / SIPs and other half in any other investment you believe is high return – that could be cryptocurrencies, NFTs, market index funds, or anything or any combination based on your risk-taking willingness.

Putting money in the fund / company is only one part of the responsibility as a retail investor. It is important to then try to objectively understand how an ESG fund has been structured or how a company reports its ESG impact. For this evaluation, we do not need any financial knowledge. We can simply read through the ESG impact pages from the company’s annual report and read some reports on how the fund we are investing in makes sure the portfolio represents ESG focused companies. But alongside these readings, it is beneficial to get a broader picture by reading a report on good ESG norms or related topics on reliable websites such as McKinsey reports which are free and seem reliable. We can also be updated on ESG investing by reading news every day (note: if you hate reading, there are enough podcasts and YouTube videos on the topic). Once we can compare our individual fund’s / company’s ESG reading to benchmark report reading, we can take a better investment decision for ourselves. For example, we would steer away from a fund that focuses only on the returns generating by the portfolio companies and go towards a fund that includes companies that have planned expenditures lined up for ESG impact. It is advisable to do these readings and comparison regularly (every month or every 3 months) even after investing because not all of our investments will be beneficial and every now and then may need some changes and shifts.

Regular evaluation in this way not only helps us take informed decisions to achieve our financial goals but also helps signal that retail investors also care about ESG and cannot be fooled. If there is a severe problem, we can raise our voice on platforms such as LinkedIn and Instagram to reach experts as well as masses to grow awareness and seek clarification. In our capacity, we can be aware, speak up and make educated / informed decisions to support and promote ESG but ensure it is not taken for granted.

ESG is still a very ambiguous topic with scope to creatively tackle and exploit the opportunity. From the discussion above, it is obvious that there is no single answer to any challenge to ESG. Hence, we must make the best bet based on all the information we have floating freely on the internet.