The Money Meets Medicine Podcast

ESG Investing: The Pros and Cons

By Jimmy Turner, MD
Host of Money Meets Medicine

What if I told you that you could marry your investing principles to your moral compass? That you could invest in social and environmental companies that represent your beliefs and moral imperatives? Or companies that actually treat their employees the way you’d want to be treated? This is called ESG investing. Is it too good to be true? Or is ESG investing something you should consider in your investing portfolio?

From a niche concept, Morningstar shows how rapidly this sector has grown over recent years. The leap from $20 billion in 2024 nearly hitting $400 billion by 2024 underlines how mainstream ESG has become among both individual and institutional investors seeking more than monetary rewards from their portfolios. Some estimates show ESG investing may reach into the trillions as soon as 2026.

But what’s fueling its meteoric rise? And more importantly, can you really bank on it for solid returns? We’ll unpack these questions by looking at how ESG investments stack up against traditional ones and if you – like other investors – should flock toward them.

We will also discuss the elephant in the room – figuring out which investments are truly ESG-compliant amidst varying standards. It’s not as straightforward as you might think. By sticking around, you’ll also get insights into alternative ways to make an impact beyond your portfolio.

Last but not least, we tackle a tough question: Do these investments actually lead to real-world change?

Table Of Contents:

The Surge of ESG Investing

Imagine a world where your investments do more than just grow—they help make the planet better. That’s what’s driving the meteoric rise in ESG (Environmental, Social, and Governance) investing.

This isn’t just about feeling good. Investors are flocking to ESG because they believe companies focused on sustainability can outlast those that ignore these crucial factors. It’s not just a trend—it’s becoming a staple in portfolios worldwide.

But why such an explosion of interest? It could be due to increasing news regarding climate change and social justice issues, which then leads to a desire among investors to put their dollars where their values are. Perhaps, it is fueled by a desire for transparency among companies given the recent events with large social media companies like Facebook compromising data.

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ESG investing soared from $20B to $400B in just 2 years. Investors are betting big on sustainability, making it a must-have in portfolios. #ESGInvesting #SustainableFinance Click to Tweet

Evaluating Financial Returns in ESG Investing

Non-negative Correlation with Financial Returns

The landscape of investing is evolving, and ESG (Environmental, Social, Governance) investments are at the forefront. Some studies have shown a promising link between ESG criteria and financial performance.

Specifically, over two-thirds of the research concludes that there’s a non-negative correlation between incorporating ESG principles into investment strategies and achieving solid financial returns. This means that by prioritizing companies that care about the planet, treat people well, and govern themselves effectively, investors don’t have to sacrifice profit for principle.

This revelation has sparked interest among both individual investors and large funds alike. It challenges the outdated notion that socially responsible investments are merely moral choices with no real fiscal benefit.

Yet, ESG investing is not all rainbows and unicorns as we will discuss below. It often has higher investing costs, which begs the question of whether it is worth it.

Vanguard’s ESG Fund Performance

The non-negative correlations mentioned above have to be interpreted in context. Let’s use an example.

Vanguard’s largest ESG fund demonstrates a 99.74% correlation with the S&P 500’s performance over recent years. What does this mean? Essentially, Vanguard’s ESG-focused portfolio mirrors nearly identically the broader market’s ups and downs while adhering strictly to ethical investment standards.

Here are the top 10 holdings found in the ESGV fund from Vanguard:

Now, let’s take a look at VOO, Vanguard’s S&P 500 fund‘s top 10 holdings:

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Not a lot of difference, is there?  It would not be surprising then that the ESGV fund from Vanguard does as well as the VOO fund.  If you are comparing two identical apples, I suspect they would taste the same.

The Debate on Performance

Consensus remains elusive in academic circles regarding whether or not ESG companies universally outperform traditional ones financially over time.

In part, because evaluating such metrics involves accounting for myriad factors — from industry sector differences to regional economic conditions — skeptics argue more data is needed before drawing definitive conclusions.

Yet as public sentiment continues shifting towards sustainability and corporate responsibility grows increasingly linked with profitability, thanks partly to innovative technologies reducing operational costs, it seems likely debates will eventually lean favorably toward green investing strategies.

While it may make sense that companies that “govern” well (the “G” in ESG investing) and treat their employees well would do better, this hasn’t necessarily been born out in studies.  And, this brings us to another challenge faced by ESG investments.  How do we know that these companies are actually governing well?  How is it measured?

Challenges in Defining True ESG Investments

Inconsistencies in Fund Composition

Finding the true north star of ESG investing is like navigating through a dense fog. Different organizations have different compasses, leading to varying ESG ratings and criteria. This divergence creates a landscape where two funds labeled as ‘ESG’ might look as similar as chalk and cheese on closer inspection.

The root of this confusion lies not just in subjective interpretations but also in the absence of universal standards. While one fund may prioritize renewable energy initiatives, another could give more weight to social justice causes, reflecting stark differences under the same ESG umbrella.

Presence of Non-ESG Aligned Companies in Funds

Beyond these inconsistencies, there’s an elephant in the room: companies that don’t quite fit the bill making their way into so-called ESG funds. It’s akin to finding plastic straws at a green conference—unexpected and somewhat contradictory.

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An example of this is shown above. If part of your ESG principles involve investing in companies that respect privacy, for example, there are notable companies on that ESGV top 10 holdings list you may otherwise avoid. Yet, they are there.

This situation often stems from broad or lenient screening processes used by some funds. Consequently, investors keen on advancing environmental stewardship or social equity might inadvertently support businesses whose practices run counter to these ideals. As such, due diligence becomes paramount for anyone looking to invest with impact truly at heart.

Another reason this inconsistency may occur is because there is a natural tension between those who want to see profits from these companies and those who are investing to support ESG initiatives. This tension results in conflicting interests that may muddy the waters.

The thought process here says, “Maybe if we invest just enough in this one suspect company, we can meet the standards required by ESG criteria, without losing profits.” You can see why this is problematic when you are investing based on both moral and profit-driven metrics.

Questioning the Causal Link Between Investment and Change

When we peel back the layers on ESG investing, a burning question emerges: does funneling money into ESG funds actually drive positive change? The idea sounds compelling. By choosing where to put our dollars, we can push companies towards better practices. But is this theory mirrored in reality?

A deep dive reveals that establishing a direct link between investment flows and tangible outcomes isn’t straightforward. For instance, despite the surge in ESG fund investments, quantifying their impact on corporate behavior or environmental improvements poses challenges. This complexity stems from numerous factors including diverse definitions of what constitutes an ‘ESG-compliant’ investment and varying methodologies for measuring success.

This ambiguity doesn’t mean efforts are futile but underscores the need for more rigorous frameworks to evaluate effectiveness. Investors are increasingly vocal about wanting not just to see their portfolios grow but also to contribute meaningfully towards societal goals. Therefore, transparency in how funds operate and achieve these objectives becomes crucial.

Alternative Impact Outside ESG Investing

Direct Impact through Volunteering and Charitable Giving

After reading this, there is a chance you aren’t convinced of the merits of ESG investing. Well, fortunately, there are alternatives here that may lead to a more direct impact.

Giving your time or money directly to causes can often feel more tangible than ESG investing. When you volunteer, you’re on the ground, seeing the change happen in real time. And when it comes to charitable giving, research shows that nonprofits value cash flexibility over restricted funds. This means your dollar can go where it’s needed most, be it for disaster relief efforts or community programs.

Supporting Local Organizations for Broader Change

Your local community likely offers many opportunities to drive societal improvements from within. By supporting local businesses committed to sustainable practices or nonprofit organizations focused on social justice, education, or health care reform, you become part of a collective effort toward broader change.

This engagement doesn’t just bring about direct benefits; it fosters a sense of community and shared purpose that can ripple outwards far beyond its initial scope. An added bonus? It strengthens the economic foundation of your neighborhood by keeping dollars circulating locally.

Conclusion

ESG Investing is changing the game. It’s grown massively, showing us it’s more than a trend; it’s here to stay.

Remember, diving into ESG doesn’t just promise potential returns but also aligns your portfolio with your values. Yet, not all that glitters is gold. Navigating through what truly counts as an ESG investment can be tricky because of inconsistent standards.

Make no mistake: Your impact isn’t limited to where you put your money. Engaging directly with causes and supporting local organizations can amplify your positive footprint on this planet.

Last up, question everything. While investing in ESG funds feels right, always ask if they’re driving real change or just ticking boxes.

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