Thought Leadership in Action

Environmental, social and governance (ESG) funds are an increasingly popular — and controversial — financial investing option. Advisors can help clients assess the merits of ESG funds, the expected returns and how to get started. 

ESG funds are investment vehicles that focus on sustainable, ethical and socially responsible investing while still generating strong returns. ESG investing criteria can include a company’s commitment to renewable energy, ethical labor practices and board diversity. Adopting an ESG approach to investing can provide more visibility into the actions of companies and funds, including sustainability efforts and diversity initiatives. Advisors can help interested clients recognize the opportunities, challenges and risks associated with these types of investments. 

Advantages of ESG Funds 

One of the primary advantages of ESG funds is that they help investors diversify their portfolios while staying true to their values. Investors can put their money in successful companies that are also trying to make the world a better place. ESG funds can also help investors spread their risk across multiple sectors and industries, and focus on assets with lower systemic and long-term risk. 

ESG approaches, like any investment approach, can produce a range of returns. However, well-managed sustainability investments can achieve similar returns to and even outperform traditional vehicles. Performance data from Morningstar, for example, shows that while the Morningstar US Sustainability Index fell 18.9% in 2022, it outperformed benchmarks such as the Morningstar US Large-Mid Cap Index and the Standard & Poor’s 500. 

Disadvantages of ESG Funds 

ESG funds may align with an investor’s ethical values, but that doesn’t guarantee that the fund will be a good investment. With a concentrated focus on companies that meet ESG criteria, investors may miss out on more profitable investment opportunities. Another issue is that the criteria used to evaluate a company’s ESG score can vary greatly. This lack of standardization is often cited as one of the biggest issues with ESG investing, as it makes it difficult to compare different funds or know whether the criteria are valid or relevant.  

Financial advisors should work with clients interested in ESG investing to identify opportunities that align with their priorities while also generating returns. This may require difficult choices or compromises, as companies or indexes may perform well on one aspect of ESG, such as environmental criteria, but underperform on others.  

Developing an ESG Strategy  

Clients should be aware of the undeniable impact of ESG on investing trends and company behaviors, even if they’re not personally investing in such funds. In 2022, ESG accounted for $1 of every $8 in assets under management in the U.S. Sustainable funds are seeing higher demand and traditional funds, including from large investors that can drive investment trends. 

Ultimately, ESG funds carry risk like any other investment, and financial advisors play a crucial role in helping clients understand the potential risks and rewards. Some clients will want to invest in line with their values while pushing for even more transparency and positive change from corporations. Other clients will feel that ESG generates insufficient returns or is too political for their tastes, and they’ll shy away from strategies labeled as such. 

For clients who choose an ESG approach, start with a focus on the issues that matter most to them and set specific goals, such as prioritizing funds with high sustainability scores. Investors should be aware that rating agencies have been criticized for assigning ESG scores to companies that don't necessarily reflect their actual performance. The lack of standardization in ESG criteria also makes these assessments more difficult. Advisors should help clients do their research and understand what the various ESG scores mean as they dive into ESG investing.