Investors are increasingly interested in companies committed to a sustainable future. Environmental, social and governance (ESG) criteria are a set of metrics that guide sustainable and responsible companies.
You can build a portfolio that promotes a better future by seeking out stocks that fulfill ESG criteria. Learn more about ESG criteria and stocks now to incorporate ESG rating into your investing strategy.
Strong ESG Programs Can Increase Stock Liquidity
Because ESG stocks typically boast better operational performance and a lower cost of capital, they are favored by investors in all markets, even bear markets. This makes them highly liquid.
High stock liquidity means ESG stocks are easy to buy and sell rapidly. When stocks have high liquidity, your trade can be executed soon after you place it, and get in or out at the price you want.
This is especially important during down markets. In the event you need to sell off a portion of your portfolio to protect against loss or cover an emergency expense, you need stocks that sell rapidly. Otherwise, the bid-ask spread could be far greater than you were prepared for.
ESG Investing Trends
As ESG investing grows in popularity, the market is seeing new trends in how investors incorporate that ESG data into their portfolio. There is a shift toward renewable and alternative energy stocks and a growing global interest in tracking ESG criteria in international markets.
With stronger cap and trade legislation imminent and growing public demand for cleaner solutions, now is the time for investors to rebalance their energy portfolio toward wind, solar, and other renewables. Using ESG criteria to identify the strongest stocks in those categories can minimize your risk exposure while still allowing you to get in early on stocks that are poised to become the new energy giants.
Interest in ESG investing is even spreading internationally as KraneShares jumps into the ESG fray with its new China fund. Incorporating international companies into your portfolio is key to fully diversifying your portfolio, and ESG criteria can help you manage risk exposure and ensure you invest ethically on a global scale.
While different databases use different metrics to evaluate ESG stocks, they all generally look for similar indicators of risk and responsibility. Here are some of the key ESG metrics used:
- Dependence on carbon-intensive supply chain
- Land or ecosystem disturbance caused by company’s operations
- Environmentally controversial investments
- Toxic emissions and waste
- Discrimination and diversity
- Labor standards controversies
- Human rights concerns
- Tax gap
- Anti-competitive behavior
- Bribery and corruption controversies
Databases typically use dozens or even hundreds of different metrics to evaluate ESG criteria in a stock. The list above is only a small subset. When you’re exploring different ESG databases, you can look at the specific metrics they rely on to make to give their ratings. Then, decide which metrics best reflect your investing goals.
CFA Institute to Develop ESG Disclosure Standards for Investment Products
While interest in sustainable investing strategies has been increasing for the last 30 years, mutual funds and asset managers have yet to establish a consistent way to evaluate investments by these criteria.
ESG data has become somewhat more readily available thanks to the internet. However, a major roadblock still exists: companies aren’t yet required to report on a specific, standardized set of ESG criteria. The lack of standardization can make it harder to compare stocks as one company might voluntarily announce its environmental policies while another only announces its labor policies.
To address this gap in data, the CFA institute published a proposal for developing voluntary ESG disclosure standards for investment products. The disclosures would allow the CFA to evaluate a company’s ESG programs and then provide investors with an easy-to-use reference for identifying ESG stocks. A first draft of the standards is expected in May 2021.
What are Environmental, Social, and Governance (ESG) Criteria?
ESG criteria are a broad set of criteria in each of the 3 categories ESG investors evaluate. There are no mandatory reporting requirements, so it’s not always possible to evaluate stock by these criteria.
Among those who voluntarily report, these are the criteria as laid out by the CFA:
Environmental criteria include measures of how a company’s operations affect the environment. This includes harm reduction criteria like low or no carbon emissions as well as proactive, positive impact criteria like restoration projects or charitable programs.
Here is a list of the basic environmental criteria:
- Carbon emissions
- Air and water pollution
- Waste management
- Energy efficiency
- Water scarcity
This is a broad category that considers both customer and employee satisfaction with the company.
The criteria include:
- Labor standards
- Human rights
- Data protection and privacy
- Community relations
- Gender and diversity
- Customer satisfaction
- Community relations
Governance refers to the internal operations and leadership of the company. The criteria measure levels of transparency, accountability and political activity.
Here are the key measures used to evaluate good governance:
- Board composition
- Executive compensation
- Audit committee structure
- Political contributions
- Bribery and corruption
- Whistleblower schemes
Pros and Cons of Environmental, Social, and Governance (ESG) Criteria
There are a lot of important reasons to use ESG criteria to build your investing portfolio. However, there are also some important limitations to consider.
Here are some of the major pros and cons of ESG criteria:
|Align investments with your personal values
|No clear-cut definition of ESG criteria
|Boost socially conscious businesses
|Poor performing stocks can still have high ESG ratings
|ESG ratings make it easier to compare stocks by sustainability criteria
|Excluding high performing stocks with bad ESG ratings might hurt your returns
|ESG ETFs make it easier to incorporate ESG data into your strategy
|ESG criteria are less useful for short-term trading
|Strong ESG performance is often (but not always) an indicator of strong overall performance
|ESG data is still not available for all stocks
How Environmental, Social and Governance (ESG) Criteria Work
When you use a resource like MSCI, Bloomberg or any of the sources that offer ESG ratings data, you’ll find a proprietary score given by that source. This will often be a letter grade or a point-based score.
The main ESG rating will be an averaged score across all the metrics that source uses to grade ESG stocks. Many sources also provide individualized scores for each of the categories grouped together under the ESG umbrella.
With this, you could base your strategy on which of these categories you prioritize most. If environmental criteria are your top concern, check out this easy, profitable way to nail the “E” in ESG investing.
As an investor, you can use this information to build an investing strategy based on your goals. An impact investor would want only the best ESG stocks which have high grades across all the categories. A conservative investor, on the other hand, may use ESG as a measure of risk exposure rather than social or environmental responsibility.
What are the Best ESG Stocks?
If you’re ready to join in on the ESG investing boom, start by adding a few of the best ESG stocks that consistently receive the best ratings. For an effortless approach, consider an ESG ETF like these 3 ESG ETFs you don’t know about but should. These ETFs enable you to invest in all the best ESG stocks in one fell swoop.
To incorporate higher growth potential into your ESG investing strategy, here are 3 penny stocks to watch if you’re searching for ESG stocks right now.
You can also check out our list of the best ESG stocks below:
|West Pharmaceutical Servs
|Cadence Design Sys
|Marsh & McLennan
|iShares ESG Aware MSCI EM ETF
|FlexShares International Quality Dividend Dynamic Index Fund
Use ESG Ratings to Build a Low Risk, High Impact Portfolio
ESG ratings are a useful method for evaluating the risk of a stock from a broader, more future-oriented lens. These criteria allow investors to uncover exposure to risk that doesn’t typically show up on a financial statement.
For impact investors and anyone looking to build a portfolio that promotes a greener, more socially responsible future, ESG ratings are also a useful measure for identifying the best stocks to include in that portfolio. Whatever your investing goals are, start incorporating ESG ratings into your stock picking process today!