ESG investing is a hot topic, kind of like AI. It seems like it's everywhere, but is it a flash in the pan or here to stay?
Spoiler: ESG investing isn't going anywhere, and that's a good thing because it allows financial planners to build portfolios that offer long-term security while providing peace of mind to your clients. Sounds like a win-win, right?
But how do you help your clients put their money where their values are, so to speak? We're going to unpack this topic in some depth, so get comfortable.
What Is ESG Investing?
ESG investing is short for Environmental, Social, and Governance investing. It’s an investment approach that considers how companies manage environmental and social issues and governance structures as well as financial metrics. For financial planners, you’re looking at how ESG factors can affect investment risk and fluctuation of returns over time.
If you’re building a portfolio based on ESG, you may look at an organization’s actions or stance on these topics:
- Waste management policies, sustainable shipping practices, or use of renewable energy (environmental)
- Fair labor practices, community engagement, or product safety (social)
- Executive pay, anti-corruption measures, or board diversity (governance)
You would use this knowledge alongside traditional financial metrics to make better-informed decisions on your clients’ behalf.
Listen up: Adam is joined by Jenny Coombs, Director of Content and Development at US SIF to discuss ESG investing in this episode of BIF Bites!
ESG vs SRI vs Sustainable Investing
With ESG investing, you’re weighing how well a company manages things like climate impact and employee wellbeing to see what kind of risks exist. Value alignment is more of an added bonus, while the goal is long-term performance. But ESG investing isn’t the only type of investment approach that factors in socially responsible, non-financial considerations. Let’s look at some other options.
Socially Responsible Investing
Socially responsible investing prioritizes values first by excluding or including investments based on ethical, moral, or religious beliefs. Typically, you would align their portfolio with their personal convictions through negative screening like avoiding investing in tobacco companies or their parent companies if the client was anti-smoking.
Sustainable Investing
Sustainable investing is a more proactive, broader approach to investing. You wouldn’t just avoid companies deemed “bad,” you’d also choose to invest your clients’ funds in companies that have long-term growth potential and are actively improving the environment or society, like a shoe manufacturer that pays workers a living wage and uses eco-friendly materials over a company that is continually cited for human rights violations and polluting the nearby river.
A Case Study: Acme Company
Acme Company is a Fortune 500 business but has a reputation for selling items that tend to self-destruct or malfunction at the worst possible moments; thus, they are very dangerous for both their customers (mainly coyotes) and the environment. We would recommend not investing in them, but the reasoning is different depending on the investment approach we take.
- ESG investing: We would pass because the product recalls, consumer injury, and lawsuits make this a terrible risk for long-term investing.
- SRI investing: We would pass because your client is pro-coyote and would never invest in a company that actively harms them.
- Sustainable investing: We would pass because they are actively harming the environment, its beings, and the future through their incendiary devices.
Why ESG Investing Matters to Financial Planners
Now that you feel confident in what ESG investing is, let’s talk about how it can support your practice.
Rising Client Demand for Values-Aligned Portfolios
While ESG investing doesn’t make value alignment a top priority, today’s clients are increasingly likely to do so. Millennials and Gen Z investors are especially driving the demand to invest in companies that have stronger track records on climate change, corporate ethics, and social equity. And yes, even the boomers and Gen X are paying attention to ESG; don’t count them out.
Regulatory Trends and Fiduciary Responsibilities
Governments worldwide are rolling out standards for ESG disclosures. For financial planners, this means it’s no longer optional to consider ESG factors in your advisory process. It’s part of fulfilling your fiduciary duty to know how these factors affect investment outcomes.
A Tool for Risk Management
Companies ignoring ESG risks (like lax environmental policies or poor governance) are less attractive from a risk standpoint. Think scandals, penalties, and lawsuits. Good ESG practices can signal a company’s long-term stability and usually amounts to less unexpected volatility, making it a critical tool in your risk assessment arsenal.
ESG Metrics and Reporting
The tricky part of ESG investing is knowing what metrics to trust. ESG evaluations aren’t standardized yet, but you don’t have to be Sherlock Holmes to figure it out.
Data Sources and Scoring Systems
ESG data can come from three main sources:
- Corporate disclosures: Most publicly traded companies publish annual ESG or sustainability reports, or their ESG-related risks and initiatives may appear in standard financial findings
- Third-party rating agencies: Firms like Sustainalytics, Refinitive, Bloomberg ESG, MSCI, and FTSE Russell use disclosed data and other sources to score organizations on ESG factors.
- Independent research bodies: Frameworks like the Task Force on Climate-related Financial Disclosures (TCFD) and Sustainability Accounting Standards Board (SASB) can guide consistent reporting.
Why Transparency Matters
Transparency is gold in ESG investing. If a company is vague or incomplete in its ESG reporting, you can’t ignore that red flag. Plus, regulators are demanding greater consistency in these disclosures, so it’s easier for you and your clients to differentiate between companies genuinely committed to ESG goals and those just slapping “sustainable” on their marketing.
Practical Considerations for Portfolio Construction
How do you actually create an ESG-aligned portfolio? Here are the practical steps.
Screening Strategies
- Negative Screening filters out companies involved in controversial industries (think tobacco or coal). While it’s used more in SRI, it’s still a simple strategy when looking at long-term financial stability and success.=
- Positive Screening focuses on including companies with strong ESG track records.
- Best-in-Class Screening identifies the top ESG performers within a particular industry, even if the industry itself isn’t squeaky clean.
ESG Integration vs. Thematic Investing
- ESG Integration weaves ESG factors throughout the traditional investment analysis process, assessing risks and opportunities that could impact financial performance over time. It’s subtle but effective.
- Thematic investing involves selecting investments based on ESG-specific themes like renewable energy or gender equity. Instead of evaluating ESG performance across all sectors, thematic investors concentrate capital in companies or industries actively contributing to a social or environmental goal. Think of it as curating a themed playlist but for your clients’ portfolios.
Due Diligence Tools
Platforms like Morningstar Sustainalytics or MSCI ESG Manager simplify fund selection and help you perform due diligence. They’re like the power tools in your investment toolkit. Don’t build a house with a hammer when you’ve got a nail gun handy.
Challenges and Criticisms of ESG Investing
No conversation about ESG investing would be complete without addressing the criticisms.
Greenwashing
Some companies exaggerate their ESG efforts to attract investors, a.k.a. greenwashing. It’s your job as a financial planner to dig deeper. Labels don’t mean much unless they’re backed up by real action.
Balancing ESG with Financial Goals
Sometimes there’s a trade-off between achieving ESG goals and financial returns. But the latest research shows that, when done right, ESG doesn’t have to compromise returns. Win-win, remember?
Political and Legislative Pushback
Some states are pushing back against ESG investing. In 2023, Missouri’s Secretary of State, Jay Ashcroft issued a rule requiring financial advisors to obtain written consent from clients before recommending any investment based on ESG or “nonfinancial objectives.” While a federal judge blocked the rule in 2024, citing a violation of federal securities law, it’s important to be aware that some lawmakers are targeting this approach of investing.
Opportunities for Financial Planners with ESG Investing
This is your time to shine! Financial planners are perfectly positioned to educate clients about ESG, advocate for responsible investing, and lead this movement. Clients are looking for guidance, and you can be the one to help them make sense of it all.
As ESG investing continues to grow, the opportunity for financial planners to drive meaningful impact while delivering value to clients has never been greater. By educating yourself and leaning into the tools and strategies available, you’ll not only build better portfolios but also better relationships with your clients.
Elevate Your Career as a CFP® Professional
Becoming a CERTIFIED FINANCIAL PLANNER® gives you the knowledge needed to build comprehensive financial plans that align your clients' goals with their values and priorities. At BIF, we can help you meet your requirements, from completing the required CFP Education programs to passing the CFP® Exam with The BIF Review.
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