ESG is all about putting your money where your values are – literally. This practice takes investors a step beyond merely shopping local or avoiding big box stores. When you invest according to ESG guidelines, you’re putting your capital to work with companies that share your values and beliefs in the way they work.

ESG investing, explained

ESG stands for “Environmental, Social, and Governance,” and is synonymous with sustainable investing, impacting investing, and socially responsible investing.

This practice is growing amongst investors and investment firms are starting to take note.In fact, many companies now offer financial products that follow ESG criteria, while others are working to better their scores to appeal to a broader range of investors.

ESG scores are assigned by various analytical institutes based on differents sets of criteria. Different institutions have their own methodology, which can mean the same investment has a different rating depending on the approach taken.

ESG investing is about aligning your portfolio with your moral compass. However, there is also evidence that ESG investments perform similarly to traditional investments – at less risk to the investor.

For example, a recent study from MSCI found that ESG investments have positive impact valuations and performance. In fact, their findings show that companies with higher ESG ratings perform better in three specific categories: higher profitability and dividend payments, lower tail risk, and lower systematic risk exposure.

So, in other words, companies that adhere to ESG guidelines experienced less profit and earnings volatility, lower capital costs, and fewer instances of fraud, accounting violations, and natural resource violations.

Conversely, companies with lower ESG scores showed that they were more prone to high capital costs, volatility in the stock market, and at a higher risk of major ethical and regulation violations. These lead to lower profitability and dividend payments, higher betas, and more incidences of corruption, fraud, and even bribery.

Additionally, a 2019 white paper from the Morgan Stanley Institute for Sustainable Investing compared the returns from various sustainable funds to traditional investments and found that total returns were similar between 2004 and 2018.

The same study also discovered that sustainable funds experienced consistently lower risk than conventional funds, regardless of asset class.

Furthermore, during turbulent markets – such as in 2008 and 2015 – traditional funds experienced a larger downside deviation than sustainable funds. This meant that traditional funds saw a higher potential for loss than funds with higher ESG scores.

Other studies have shown that ESG may actually outperform conventional investments.

For example, JUST Capital maintains a fund that selects ESG investments from the top 50% of companies in the Russell 1000. Since their inception, JULCD has returned 16.54% annualized returns compared to 15.31% from the Russell 1000.

The largest drawback of an ESG approach is the extent to which it can impact diversity in your portfolio. For instance, some ESG funds operate similarly to SRI investing in that they exclude entire industries. Typically, these are left out due to environmental regulations – such as oil and tobacco companies. Furthermore, many companies that adhere to ESG guidelines are large-cap, which limits your exposure to small- and midcap stocks. This impact on your diversity has the potential to limit your returns.

What this means for you

ESG investors can mitigate some of the risks that come with ESG investing—and reap the rewards—by including companies and industries that have proven track records of making improvements in ESG standards.

After all, no company will be perfect – but many are upping their standards.