The idea of investing in companies with strong records of environmental stewardship, social responsibility, and strong corporate governance -- "ESG investing" -- is surging in the stock-picking world. The U.S. SIF Forum for Sustainable and Responsible Investment estimates that from 2016 to 2018, socially responsible investing funds in the U.S. increased by 38% to $12 trillion.
Despite the coronavirus pandemic, research provider ETF Flows says ESG investments are continuing to grow in 2020, up a further $15 billion in the year's first half. Annualize that growth rate, and ESG is on track to grow 40% faster this year than last year (when $21.4 billion was poured into ESG funds, according to Morningstar data).
What's the deal?
Outperformance & popularity
As it turns out, ESG investing outperforms many other forms of investing in the stock market. Among U.S.-based, ESG-focused index funds surveyed in Q1 2020, 10 out of 12 outperformed the S&P 500 according to MarketWatch, and 11 out of 11 non-U.S. ESG-focused funds beat their respective international benchmarks.
Why are ESG funds outperforming the competition? Popularity is one reason. Studies show that younger (including Millennial and Gen Z) investors tend to favor investments in companies that are good global citizens. Investors who came of age in 2000 or later are said to be "three times more likely" than investors at large to agree that business must "serve communities and society" reports MarketingDive, and to favor a company associated "with a social cause."
When you consider that more than 83 million of America's 328 million citizens hail from the millennial cohort alone -- more than one person in four -- that's a huge number of investors putting their money where their values are. And it probably doesn't hurt that many of the trends supported by ESG investors mirror some of the best-performing segments of the stock market lately.
Environmentally conscious energy
Consider just the most obvious example of ESG investing: renewable energy companies working to transition from an oil-and-gas-based economy to an economy that uses solar and wind power to generate electricity, which can be stored in batteries and used to power cars and trucks.
Electric car company Tesla (TSLA -6.37%) -- which also makes solar panels to generate electricity, and solar batteries to store it -- is the standard-bearer for this movement, but it's far from the only success story.
Few stocks have performed as fabulously as Tesla in 2020, which has seen its share price roughly quadruple since the year began. But the remarkable success of rival electric truck company Nikola (NKLA -6.32%), which doubled in the week following its IPO in June, as well as clean "fuel cell" energy stocks like Plug Power (PLUG -5.38%) and Bloom Energy (BE -4.37%) over the past month, demonstrates the intense popularity of environmentally responsible stocks right now. The gains these stocks have been racking up have also contributed mightily to the outperformance of ESG funds over the broader stock market.
Treating workers right ...
In today's political climate, what makes a company "socially responsible" can generate heated debate. Without trying to rock the boat, it's at least easy for everyone to agree that treating workers right is a social good.
To that end, it may be worth reviewing the performance of some of the publicly traded companies that place highly on Glassdoor's list of the "best places to work in 2020." Since the calendar flipped, e-signature company DocuSign, the third-best place to work in the country according to Glassdoor, has more than doubled in share price, while No. 1 HubSpot is up a very respectable 41%.
Glassdoor notes that these companies win praise from their workers -- and win high rankings on its survey -- "for promoting transparency with employees, offering career growth opportunities and providing work driven by impact and purpose." Granted, winning "social" praise is no guarantee of stock success. No. 10 on Glassdoor's list, Southwest Airlines, has had an undeniably rough year so far. At the very least, though, it seems that treating employees right hasn't hurt these companies' businesses one bit, and may contribute to a stronger hiring pool.
... and treating shareholders fairly, too
Last but not least, let's take a look at governance, the "G" in ESG investing. The Harvard Law School Forum on Corporate Governance recently observed that "improved governance can enhance long-term shareholder returns." And that makes sense.
For example, when management is held accountable to shareholders by eliminating "classes" of directors on its board, such that all directors can be voted in (or out) every year, that tends to focus those directors' attention on how well their company is being run. When management is highly rated for explaining its business strategy, setting and meeting goals, and keeping the language of its earnings releases clear and understandable, this makes it easier for shareholders to tell if the company is being run well -- informing how they should vote on those director elections. And it stands to reason that when companies are kept better on track, their returns will be more profitable for their shareholders.
When you add up all three elements -- the E, the S, and the G -- a compelling picture begins to take shape. A recent study by "sustainable finance" company Arabesque found that S&P 500 stocks ranking in the top quartile for these three attributes outperformed those ranking in the bottom quartile by a whopping 25% in the five years running from 2014 to 2018 -- and again, this is all independent of how profitable, fast-growing, or popular the businesses might be otherwise.
That's proof positive you don't have to sacrifice your principles in order to make money investing in stocks.