Retirement investing is a long-term play. Even if you're late getting started with your retirement savings, your portfolio should be around for four decades or more. That extended timeline is one reason why ESG investing fits nicely into your retirement savings plan.
ESG investing involves evaluating a company's performance on environmental, social, and governance issues along with financial analysis when making investment decisions. A company's environmental track record includes its approach to emissions, resource management, pollution, waste management, and energy efficiency. The social category involves labor practices, data protection, workforce diversity, and local community relations and impact. And governance criteria include executive compensation, political activity, ethics, and risk management.
According to a study by the Morgan Stanley Institute for Sustainable Investing, 71% of people believe they can influence human-caused climate change by their investing decisions. Among Millennials specifically, that percentage is higher at 85%. That's the most obvious reason to invest in companies that pursue ESG initiatives -- to support sustainability. Doing so broadens your impact well beyond what can be accomplished by changing individual behaviors.
Specifically investing retirement savings aligns with the timeline and complexity of the underlying issues, too. There are no easy, quick answers to climate change, pollution, or gender bias in the workforce, for example. Solving for those problems takes time and money -- two things you probably have as a retirement investor. It's likely that the bulk of your savings is housed in a retirement account, and your investment timeline is measured in decades rather than years.
Market-level returns with lower volatility
A less obvious but more immediate reason to invest in ESG is for the returns. There's a lingering idea out there that a corporate focus on sustainability comes at the expense of financial returns. In July of this year, for example, the Department of Labor proposed greater restrictions on ESG funds in 401(k) plans -- on the argument that these funds might not be in the best interests of investors. But multiple studies and analyses published over the last few years contradict that argument.
After the coronavirus downturn in March of 2020, S&P Global Market Intelligence compared 17 large ESG exchange-traded and mutual funds to the S&P 500 index. Of the 17 funds analyzed, 14 had lost less value than the S&P 500. A broader analysis by Morgan Stanley reviewed performance of ESG mutual funds between 2004 and 2018. The conclusion? ESG funds produced returns on par with their traditional counterparts, only with lower volatility. That's a nice profile for your retirement account.
The downsides of ESG investing for retirement savers
As you might expect, ESG investing isn't without some downside. Disadvantages include non-standardized screening criteria by ESG funds, high fees, and potential availability problems.
ESG mutual funds are an easy starting point for investors who don't want to pick individual stocks. But the screening criteria for these funds can vary dramatically. iShares ESG Aware MSCI USA ETF (NASDAQ: ESGU), for example, has ExxonMobil (XOM 0.74%) and Chevron (CVX 0.59%) in its portfolio. While both companies promote their environmental records, they're still in the nonrenewable oil and gas business. That may or may not align with your definition of sustainable investing. You'll have to view fund documentation carefully to understand how your dollars are being used.
High fees are another potential trap. While there are ESG funds with low expense ratios of .1% to .25%, actively managed ESG funds can charge expense ratios of 1% or more. The cumulative effect of those higher fees can be significant over time. For an investor who saves $1,000 a month for 40 years, for example, the difference between a 7% return and a 6.5% return is roughly $300,000. Seek out those low-cost ESG funds so that you see a greater share of fund returns.
The biggest ESG downside, though, has to do with availability. You might not have any ESG options in your 401(k). You could still invest in ESG companies and funds, but you'd have to do it elsewhere, such as in an IRA or taxable account. That's a workable option, though it does complicate your efforts to maintain a target asset allocation.
Short- and long-term benefits
Data suggest that solid ESG performance is linked to stable financial growth in the near term. But it's also logical to believe that companies pursuing sustainability initiatives today should be better positioned for long-term profitability. That's most obvious with respect to the use of nonrenewable energy sources. As the supply of fossil fuels dwindles over the next several decades, they'll undoubtedly get more expensive.
In other words, some business practices have an endpoint, which might be 50 years from now or 500. Whatever the timeline, you can benefit from supporting companies that are already evolving away from those non-sustainable approaches. Today, that benefit is largely financial. Tomorrow, the benefit has broader social implications that span well beyond your balance sheet.