For a while, how much money a company brought in would be the deciding factor in whether someone wanted to invest.
However, the popularity of ESG investing (which stands for environmental, social, and corporate governance) has steadily increased through the years. ESG investing looks at businesses from a different lens, allowing investors to look past finances. This doesn't mean ignoring finances and other traditional investment wisdom altogether, but it does mean incorporating ESG standards into your investing decisions.
Here are three things to know if you're interested in ESG investing.
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1. What aspects of a company are graded
The three metrics companies are graded on are environmental, social, and governance. The environmental part not only deals with how companies' operations currently impact the environment, but also their commitment to greener operations and reversing global problems, such as climate change. This is especially true for companies that deal with fossil fuels and use high amounts of energy.
Socially, companies are graded on how they interact with customers, employees, and the greater community. Whether it's diversity (or lack thereof), employee safety, customer data privacy, or philanthropic efforts, as an investor, you should want to know where companies stand on these issues. They not only present problems now but will likely present more problems in the future, like bad employee retention or lack of top talent.
When you look at a company's governance standing, you want to make sure they're compliant, truthful with financial reporting, and transparent. You never want to go into an investment not knowing where companies stand on these issues because it could prove costly for investors. Lack of transparency or compliance can lead to misinformation, which often leads to misguided investments. As an investor, and therefore part owner, you don't want to be out of the loop of a company's operations.
2. How the MSCI scoring system works
There is no universal ESG grading system, but the MSCI ESG score is widely used to rate companies. The MSCI ESG ratings are:
- CCC
- B
- BB
- BBB
- A
- AA
- AAA
Companies rated CCC to B are considered laggards and more exposed to ESG risk factors. Companies in the BB, BBB, or A range are average; some aspects are managed well, while others may be managed poorly. If a company manages to get an AA or AAA rating, they're considered an ESG leader, managing ESG risks better than its counterparts. Less than a quarter of companies manage to get labeled as leaders, so that's a coveted title to receive.
3. Some investors may find ESG funds misleading
One cause for concern for many investors looking into ESG funds is the ironic nature of some of the companies within these funds. Although a fund's objective and purpose may say one thing, the companies within it may seemingly go against that purpose. Part of the reasoning behind that is because there can be loose definitions of what counts as ESG investing and what aspects of it are taken into consideration. Some funds may focus on all three aspects of ESG, while there may be some that only focus on one or two.
It's not uncommon to see green funds containing Big Oil. Take the iShares ESG Aware MSCI USA ETF and SPDR S&P 500 ESG ETF, for example. Those ESG funds hold companies like Marathon Petroleum and ExxonMobil, respectively. Big Oil plays a huge role in pollution just by the nature of their operations, yet they're also making some of the biggest investments in green innovation -- putting some investors between a rock and a hard place.
If you care about a particular aspect of ESG and don't want to be misled by its holdings, you should look past the fund's name and what it claims to stand for and focus on what's actually in the fund.
