Climate change and social equality have become hot button issues in today’s political environment, but with the rise of environmental, social and governance (ESG) investment strategies, people are increasingly putting their money to work alongside their words. In addition, ESG strategies have outperformed conventional strategies in recent years.
Let’s take a closer look at what ESG strategies entail, how to build them into your portfolio, and the best income-producing ESG strategies.
What Is ESG, Exactly?
ESG investment strategies combine financial factors with environmental, social and governance factors. For example, the Fidelity® Sustainability Bond Index Fund (FNDSX) invests in a bond index that excludes gambling, military weapons and other non-ESG industries as well as issuers involved in one or more severe ESG controversies.
There are several motivations when using these strategies:
- Align portfolios with an investor’s moral and ethical values.
- Generate and measure a social or environmental benefit.
- Influence a company to change its business practices.
- Achieve higher risk-adjusted returns over the long run.
These objectives are typically measured using ESG scores. While there is no industry standard, these scores typically include metrics like carbon emissions, resource usage, product responsibility, human rights and corporate social responsibility that are compared across companies to determine a relative ESG score.
These scores can then be used in a number of strategies:
- Exclusionary screening is a passive strategy that begins with an index and removes companies, sectors or countries involved in activities that do not align with ESG standards (e.g., oil companies or companies with questionable labor practices).
- Positive screening is an active strategy that involves either thematic investing in companies solving ESG challenges (e.g., climate change) or investing in companies with best-in-class ESG practices by computing an ESG score.
- Impact investing is a private investment strategy that targets a measurable positive social or environmental impact. For example, impact investments might include an affordable housing development or loans to disadvantaged entrepreneurs.
- Active investing is a strategy that involves engaging with companies and voting shares on a variety of ESG issues in order to initiate changes in the company’s policies or practices.
Building an ESG-Friendly Portfolio
Many ESG investments outperformed the S&P 500 index in 2020, according to S&P Global, with inflows to sustainable investment funds doubling to $54.6 billion in the second quarter of the year versus the first quarter. While some of the outperformance was due to companies like Tesla, there’s no doubt that investor interest in ESG investments is on the rise.
ESG Fund Performance – Source: S&P Global Market Intelligence
The easiest way to build ESG investments into your portfolio is using exchange-traded funds, or ETFs. In many cases, you can swap conventional ETFs for exclusionary ESG ETFs that have similar holdings (e.g., U.S. large-cap or bonds). You can also substitute money market funds for impact investments that offer a comparable yield.
When investing in ESG funds, you should be mindful of the funds’ liquidity, expense ratio and turnover. Many ESG funds have less liquidity and higher expense ratios than conventional ETFs, which can make them more volatile and impact total returns over time. The good news is that the rising popularity of these funds will eventually increase liquidity and push down costs.
Aside from ESG funds, investors can add individual ESG-friendly stocks to their portfolio. The best way to do this is typically thematic investing in climate-focused companies and other causes. The downside to this approach is that you have to carefully manage the position over time and holding a thematic portfolio can result in a lack of diversification.
Finally, many financial advisors and robo-advisors are offering ESG-friendly options to their clients. For example, Betterment began offering a Socially Responsible Investment Portfolio option in October of 2020 that reduces exposure to companies involved with unsustainable activities and increases exposure to companies working to address ESG challenges.
Generating an Income with ESG
Most investors associate ESG investing with typical stock market investing, but if you’re looking for income, there are still ESG options available.
Some popular ways to generate ESG income include:
- Sustainability Bonds are bonds—typically municipal bonds—where the proceeds will be exclusively applied to finance or refinance green (e.g., renewable energy) or social (e.g., affordable housing) projects.
- ESG Income Funds are mutual funds or ETFs that build a socially conscious portfolio that’s focused on income generation. For example, the PIMCO ESG Income Fund (PEGIX) invests in a broad basket of ESG-friendly bonds.
- Impact Investments provide a money market alternative with competitive interest rates. For instance, MyCNote invests in CDFIs (e.g., community lenders) and pays a competitive interest rate to investors.
You can also use conventional income-generating strategies with ESG-friendly securities. For example, the Snider Investment Method leverages stock options to generate an income above and beyond dividends. These same principles can be applied to ESG-friendly stocks to maintain an income-focused portfolio without the use of funds.
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In the end, income investors may want to consider using a range of different options to add income to their portfolio. They may replace conventional bonds with sustainable bonds, leverage options to increase income from equities and use impact investments in lieu of conventional CDs or money market funds.
One of the biggest risks of ESG investing is a lack of diversification. For example, many people choose to specifically exclude fossil fuel companies. This can cause you to miss out on significant returns if these companies do well. Searching for these companies that are more mindful of the environment and reducing emissions in the process is a good way to still invest in these stocks.
The Bottom Line
ESG investment strategies are an increasingly popular way for people to align their investments with their moral and ethical values. While there are few industry standards, a growing number of companies are making ESG disclosures and funds are incorporating ESG factors, making it easier for individuals to make their retirement portfolios more ESG-friendly.
If you’re looking to increase your income in retirement, Snider Advisors can help you master the use of options to generate income from a stock portfolio. Sign up for our free e-course or inquire about our asset management options today!