Don't worry if you don't know what ESG means. Odds are high that this acronym will become part of your vocabulary - and part of your portfolio - in the near future.
"Environmental, social and governance" funds focus on sustainable, socially conscious investing. Such investing, "has gained considerable traction and continues to be an important focus not just for institutional investors, but individual investors as well," says mutual fund researcher Morningstar
The funds factor in a wide array of issues such as carbon emissions, working conditions, diversity efforts and executive pay.
Assets under management in portfolios that use various approaches to sustainable investing have grown to an estimated $23 trillion globally, an increase of more than 600% over the past decade, according to Morningstar.
And this trend is likely to continue. Financial planners say they will increase use of ESG funds with their clients by 20% in 2018, according to a recent Financial Planning Association report.
There are about 275 ESG open-end mutual funds and ETFs available to U.S. investors, says Jon Hale, Morningstar's Director of Sustainability Research.
Morningstar, gives sustainability ratings, researches fund prospectus as well as evaluates equity funds based on the ESG profiles of the companies in a portfolios. Most ESG-focused funds do well on this measure, Hale says, adding that "it is also possible for a conventional fund to get a good sustainability rating."
Here's what you need to know about them.
ESG funds have been around for decades, and have evolved.
"Many people still see ESG investing as a strategy that excludes certain industries such as alcohol, tobacco or weapons,' says Jonathan Kvasnik, a financial adviser with Cherokee Investments. "In truth, ESG has shifted to an inclusive strategy.'
An ESG fund will include companies that have favorably addressed environmental, social and governance issues. "These factors can have an impact on the company's bottom line and contribute to its success,' says Kvasnik.
According to Kvasnik, a firm decides to deem its fund an ESG "when the fund incorporates a higher or above-average level of high-rated/scored ESG holdings.'
This, he says, is based on research and ratings by firms such as Morningstar. Companies such as Morningstar also decide whether to categorize a fund as an ESG fund based its criteria as well.
Kvasnik says there are no hard-and-fast rule for a company's inclusion in an ESG fund.
"Not all fund companies interpret ESG in exactly the same way,' he says. "While some funds may still exclude certain industries such as fossil fuels and weapons manufacturing, others may include these industries if they have favorable scores in other criteria of ESG.'
Earlier this year, BlackRock, the world's largest asset manager, announced plans to offer more products that exclude firearm manufacturers and retailers. It also said it would offer products that are firearm-free to qualified U.S. pension plans such as 401(k) plans.
Before investing in an ESG fund, Kvasnik recommends reading the fund's policy statement to understand their criteria for selection.
"Just because the fund has 'ESG' in the title, it doesn't mean it meets your definition of ESG,' he says.
Eric Weigel, the chief investment officer of financial planning and investment management firm Insight Financial Strategists says he analyzes the underlying methodology of funds/ETFs. He usually chooses the most liquid and lowest-cost alternative provided the methodology is comprehensive and comes from a respectable provider such as MSCI, which is a provider of equity and fixed-income indexes.
In general, Weigel prefers using broad-based ESG funds rather than trying "to emphasize either the E, S or G component."
The reason? There's a learning curve for investors, he says. It's hard enough to teach investors about the benefits of ESG versus the benefits of focusing on one specific aspect of ESG. "For now, we trying to walk investors into this space,' he says
With more options than ever before, Kvasnik says investors should be able to diversify their portfolios based on their risk tolerance using only ESG funds.
"There may not be as many choices in each category as non-ESG funds, but there are other ways to fill in the gaps,' he says, noting that sustainability ratings can be found for many stock and mutual funds. Morningstar, for instance, is one such provider of ratings.
There's also growing evidence that ESG factors, when integrated into investment analysis and portfolio construction, may offer investors potential long-term performance advantages, says sustainable investing pioneer Pax World Funds.
Yet, Weigel says his research suggests that investing in ESG fund will not necessarily provide higher or lower returns versus traditional indexes.
"But in terms of risk we think that ESG approaches minimize 'blowup' potential - that is negative corporate news,' he says. "We also tell our clients that the key advantage of ESG is adopting a longer-term horizon.'
The thesis, Weigel says, is that companies with superior ESG strategies will outperform with less risk over long horizons, say 10 years.
But there's a caveat. "At this time there is no real empirical backing for this statement as ESG has not been around for long enough in terms of databases and quality of data,' he says. "There is anecdotal evidence supporting this thesis but nothing statistically valid at this point.'
Still, ESGs seem to be here to stay, he says.
"(Investors) do not know much about it but they seem interested in learning more about this field,' says Weigel. "My best guess is that ESG will be fully integrated within the investment practices of large asset managers.'
Robert Powell is the editor of TheStreet's Retirement Daily www.retirement.thestreet.com and contributes regularly to USA TODAY. Got questions about money? Email Bob at firstname.lastname@example.org. The views and opinions expressed in this column are the author's and do not necessarily reflect those of USA TODAY.
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