ESG is an acronym for Environmental, Social, and Governance factors in investing.  It can be considered a superset of socially responsible investing (SRI), and is also affiliated with ethical and impact investing.  While it may be debatable how long the acronym “ESG” will last, it does seem likely that investors are likely to pay more attention to these non-financial factors the easier it gets for individual shareholders to look into their investments and see how their return is made.

Why care about ESG?

Some investors primarily consider ESG factors a matter of personal or institutional ethics, and a statement of how the investor finds it acceptable to make money rather than just caring about making more money.  More recently, some investors have come to consider ESG factors for risk management purposes, with the view that well run companies operating sustainably and ethically are less likely to get sued, fined, or politically attacked.

How has ESG performed vs “conventional” investing?

Traditionally, ethically-oriented investing has often taken a negative approach of excluding industries like tobacco or oil drilling rather than a positive approach of measuring trees planted, jobs created, or crises avoided.  This negative screening approach tends to screen out highly profitable sectors of the economy (like tobacco and alcoholic beverages), and so these funds tend to underperform the broader market, and especially underperform “vice funds” that focus on these excluded sectors.  Below the vice fund VICVX (net of a 1.2% management fee) has outperformed the S&P from 2002 until late 2018, while the socially responsible fund LMRNX has underperformed except during the early 2009 low.

ESG performance measured as a vice fund vs the S&P 500 and a socially responsible fund
ESG performance measured as a vice fund vs the S&P 500 and a socially responsible fund

Another comparison I made over 10 years ago, when I helped Bear Stearns launch a structured note linked to the outperformance of the ISE SINdex vs the S&P 500, shows how vice has literally “killed it”:

SINDEX vs FTSE4Good vs S&P500

Going forward, I expect this category to do better partly as funds get more positive, but also as direct robo-advisor platforms allow investors to directly align portfolios with their own values rather than accepting a one-size-fits all template about which companies rank best on these often hard-to-quantify and subjective factors.  This is why I don’t think Vanguard has raised many assets with its US and International ESG ETFs, despite having a top brand name and rock-bottom costs.

Going above and beyond: ESG+

Beyond these three factors, I sometimes use the term “ESG+” as an umbrella term to also include additional non-financial factors I consider when making investment decisions, especially religious and non-religious ethical factors.