ESG Myth Busting

Environmental, social and governance (ESG) investing, also called sustainable investing, has increased dramatically in popularity in recent years.

An alphabet soup of acronyms for related organizations, metrics and frameworks has grown around the subject, along with increased attention from regulators and a vigorous debate on the investment merits.

It can be hard to know what to believe. To decide whether to employ ESG investment strategies in their portfolios, investors need a clear sense of what ESG investing is and what it isn’t. Here we bust five common myths about ESG and ESG investing.

Myth 1: ESG investing will have a significant impact on my returns.

The facts: Northern Trust research finds that ESG funds do not perform better or worse than other managed non-ESG funds on a risk adjusted basis.

Some investors assume ESG investing means sacrificing returns. Others think ESG will help them outperform conventional strategies. We performed a deep analysis of ESG-oriented funds’ investment performance during the five-year period through June 2020. Our conclusion: Investing according to ESG principles did not materially improve or hinder the funds’ returns.

Although conventional and ESG approaches may produce similar returns over time, they may still result in noteworthy differences in a portfolio. In particular, ESG-aware portfolios often tilt toward large-capitalization stocks, growth stocks and shares of more highly profitable companies and away from smaller companies, value stocks and less-profitable firms. Some of the biases inherent in ESG strategies may influence overall portfolio diversification. Your financial advisor can help design an ESG investing portfolio to minimize any unintended impact.

Together, the data suggest that the primary consideration when deciding whether to employ ESG investing strategies should be your goals and preferences — not hopes that ESG will help you outperform or concerns that it will drag on performance.

Myth 2: ESG is all about excluding certain kinds of companies.

The facts: Rather than excluding companies for environmental, social or governance reasons, many fund managers integrate ESG considerations into their overall investment process.

It is true that decades ago, the first ESG funds simply excluded shares of companies that some investors object to, such as tobacco companies, weapons makers or gambling businesses. Although that approach remains available, more fund managers today integrate ESG factors such as climate risks, workforce management and corporate governance practices in order to seek greater insight into specific companies’ risks.

A study presented at the Harvard Law School Forum on Corporate Governance found that integration is now the most common approach to ESG investing, practiced by 59% of all global investors. It also found the use of exclusionary screening strategies declined from more than half of investors in 2021 to four in 10 in 2022. (Read more about ESG integration vs. exclusion.)

Myth 3: ESG is just the latest hot investment trend.

The facts: ESG investing has been around for decades. ESG investing strategies already represent enormous levels of assets and are showing no signs of slowing down.

Consider these numbers:

• More than six in 10 investment professionals surveyed by Bloomberg in November 2022 said “ESG will become a standard part of business” or “ESG issues will become more critical in the future.”
• There were 534 sustainable index mutual funds and exchange-traded funds globally as of June 30, 2022, accounting for $250 billion in assets, according to Morningstar.
• U.S. sustainable funds had a more favorable organic growth rate than the total U.S. fund universe during the three years through September 2022, according to Morningstar. (Inflows were measured as a percentage of fund assets.)

Moreover, ESG investing is especially in demand among younger generations, who may drive the market for decades. Millennials make up the largest generation in the workforce and are approaching their peak earning and investing years. They stand to inherit more than $27 trillion by 2045, resulting in a faster increase in net wealth than any other generation through 2030, according to research by the Deloitte Center for Financial Services.

A recent survey by Stanford Business School found that more than 90% of Millennials and Gen Zers say they are “very” or “extremely” concerned about environmental, social and governance issues, far higher than other generations. Members of these younger generations also are much more likely to say they want fund management companies to influence the ESG practices of the companies in which they invest.

These forces will likely continue driving ESG adoption in the coming years and decades.

Myth 4: ESG only applies to equities.

The facts: If you’re interested in ESG, you can express it throughout your portfolio across asset classes.

In both equity and fixed income portfolios, you can select individual stocks or investment strategies with favorable ESG profiles.

In fixed income, you can choose among green, social and sustainability bonds, or purchase shares of funds that hold them.

• Sustainability-linked bonds provide financing for issuers with explicit sustainability targets. More than $1.1 trillion of new sustainability-linked bonds were placed in 2021, bringing the ESG bond market to more than $2 trillion. Research by the Institute of International Finance suggests issuance could reach an annual pace of $4.5 trillion annually by 2025.
• Green bonds provide financing for projects with positive environmental impacts. According to the Climate Bonds Initiative, the green bond market also surpassed $2 trillion in 2022.
• Social bonds finance projects that pursue positive social results. According to an estimate by the International Finance Corporation, approximately $300 billion in social bonds were issued in 2022.

These securities are available in a range of fixed-income categories, including investment-grade, government, municipal and high-yield bonds.

You also may advance your ESG priorities through private market holdings, direct investments or alternatives if these options are appropriate for your portfolio.

Myth 5: ESG data isn’t reliable.

The facts: ESG data has become more standardized around frameworks maintained by independent nonprofit organizations. Sophisticated institutions offer tools and services that help investors organize, understand and analyze company disclosures.

More than nine out of every 10 companies in the S&P 500 published sustainability reports in 2020, and the number has grown since then. And the quality of reported data has improved dramatically in recent years, in part because guidance from nonprofits such as the Global Reporting Initiative (GRI), the Sustainability Accounting Standards Board (SASB) and Task Force on Climate-Related Financial Disclosures (TCFD) has helped create widely used standards and reporting frameworks.

Meanwhile, firms with deep histories and resources in financial analysis have developed rating and ranking systems to help investors interpret corporate sustainability data more consistently and use it to inform their investment decisions. ESG ratings providers such as MSCI and Sustainalytics offer robust analysis tools; Northern Trust Wealth Management has partnered with MSCI to develop client friendly ESG Portfolio Reports that provide insight into your portfolio’s performance on various ESG-related metrics.

For more on this subject, read Spotlight on ESG Ratings and Rankings.