ESG Funds: Investing for "Good"

07/31/2017 2:54 am EST

Focus: FUNDS

Chloe Jensen

Chief Analyst, Cabot Dividend Investor

ESG stands for Environmental, Social and Corporate Governance, and is a variety of ethical or sustainable investing, explains Chloe Lutts Jensen, editor of Cabot Dividend Investor.

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ESG investors try to invest in companies that have good governance and are also environmentally and socially responsible.

The “twist” with ESG is that investors believe companies with good ESG scores will also be more successful, and that they make less risky investments.

For example, an oil company that tries to cut corners is more likely to have a devastating spill—and suffer the financial consequences—than an oil company that follows environmental regulations and puts a high priority on safety.

But ESG investing isn’t just about avoiding risks, or not buying certain companies. The benefits of good ESG practices can be felt everyday as well.

For example, companies that treat their employees well and make a priority of addressing employee issues are not only less likely to face damaging lawsuits, they should also benefit from more productive employees day-to-day. That’s good for the bottom line and for investors.

So ESG investors don’t simply avoid companies or industries considered “bad,” like fossil fuels or tobacco. Instead, they seek out companies doing good, and believe they will also do well. The strategy is gaining in popularity: institutional funds’ total ESG assets doubled between 2012 and 2016.

Is there any evidence that using ESG filters will improve your investing performance? The research is limited, but so far, it actually leans in favor of ESG investing. In other words, more responsible companies do tend to be better investments.

One professor studied the performance of companies on Fortune’s “100 Best Companies to Work For” list from 1984-2009. He found that the companies were more likely to deliver positive earnings surprises than competitors, and that their stocks outperformed benchmarks by 2% to 3% per year.

If you’re an individual stock investor, you can do a lot of your own research. However, you may find it easier to make ESG investments through an ESG-focused exchange-traded fund.

The largest ESG ETF is the iShares MSCI KLD 400 Social ETF (DSI), which is nearly indistinguishable from your average large-cap fund. That’s intentional: iShares made DSI so investors with a conscience can use it as a substitute for other large cap funds like SPY.

Over the past year, the two funds’ returns have been identical. Over the past decade, DSI has gained 66%, vs. a 58% gain for the SPY. DSI has also outperformed slightly over the past five years, gaining 82% to SPY’s 78%.

iShares also has a smaller ESG investing fund, the iShares MSCI USA ESG Select Social ETF (KLD), which is more aggressively responsible than DSI.

KLD holds a smaller number of companies (112 to DSI’s 400). Companies that have positive ESG scores relative to their peers and the broad market are more heavily weighted.

Compared to the average large-cap equity fund, KLD has a slightly higher exposure to technology, industrials and real estate, and lower exposure to financials and energy. But its performance still tends to track the S&P 500 to within a few points.

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