The financial community has been abuzz about ESG funds, which have shown a surprising level of strength in recent years. And now, with a President-elect who supports sustainability waiting in the wings, the time could be right to build out a broader ESG portfolio -- as long as you understand the risks.
A bright ESG outlook
It wasn't too long ago that you didn't have the option to build a well-diversified ESG portfolio. You might have held a clean energy fund out of principle, but you also had to own positions that rated lower on ESG factors just to have a sufficient level of diversification.
Not so today. The ESG fund space has grown dramatically in recent years to the point that it may check all the boxes on your portfolio's target asset allocations -- including emerging markets, international developed markets, domestic large and mid caps, real estate, and domestic and international fixed income.
And now, with President-elect Joe Biden on his way to the White House, ESG investing will likely continue to flourish as it benefits from a more favorable regulatory environment going forward. As a starting point, Biden is expected to rejoin the Paris climate deal and reenact federal initiatives to reduce greenhouse gas emissions. More than that, Biden and running mate Kamala Harris are also likely to enact policies that go beyond the "E" in ESG, policies that encourage responsible corporate social and governance practices as well.
What happens next
While analysts largely agree that ESG funds will do well under a Biden-Harris administration, there's always the question of what happens next. Yes, Biden and Harris will likely swing the regulatory pendulum to support sustainability. But that pendulum could very well swing back the other way in four or eight years. It could even happen at the hands of Donald Trump, who's rumored to be considering a run at the 2024 election.
If you are investing for the long haul, it's always risky to overhaul your portfolio based on a four-year window of opportunity. Once you start making investing decisions based on who's in the White House, it becomes difficult to stop. You could find yourself in a perpetual state of trying to predict what will happen under this administration or the next. That's not a good place to be, emotionally or financially. You'll end up riding a stress rollercoaster every four years and, if you act on your predictions, you might inadvertently lower your investment returns, too.
Take a measured approach
If sustainability is important to you, it's appropriate to increase your exposure to companies with strong ESG initiatives and track records, either directly or through ESG funds, with a caveat. You're not making these moves as a strategy to get rich while Biden is president -- you're making them because they're right for you long term. You can stick to the long-term approach by remaining disciplined about how you choose your ESG positions.
When selecting individual stocks, for example, evaluate the business model, leadership team, industry dynamics, financial strength, and cash flow, in addition to the ESG ratings.
To evaluate ESG funds, take care to understand the fund's screening process. The presence of ESG, clean energy, or sustainability in the fund's name doesn't mean much. Dig in and find out how companies are selected for the portfolio. Review the holdings carefully, too, to ensure you aren't overexposed to companies like Apple, Microsoft, and Amazon. These are popular in both ESG and traditional funds. Check the fund's performance history and also put your eyes on the expense ratio. Expenses for ESG funds can be on the high side relative to traditional funds.
Finally, don't overlook diversification. Focusing your investing on the ESG space naturally limits your diversification. That's not to say you should invest in ExxonMobil to counter that, but just make sure your holdings are spread appropriately across individual companies, asset classes, and even geographies.
Focus on the long term
Building out a broader ESG portfolio may be the right move from the standpoint of your worldview and values. Make sure it's also the right financial move by staying diversified and also disciplined in your selection process. You certainly want to benefit from ESG investing in the short term, but your decisions have to make long-term sense, too.