What It Is, How It Works, and Why It Matters

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• ESG investing is a type of investing that considers a company’s sustainability and societal impact.
• Some evidence suggests ESG investing outperforms traditional investing, but there’s a lot of debate.
• ESG investing can also have downsides such as added cost and complexity, so investors should understand what they’re getting into.

Environmental, social, and governance (ESG) investing is a type of investing strategy that is seen as a more sustainable way to invest in the market. By choosing companies that take into account environmental, social, and governance factors, or screening out companies that do not meet certain ESG criteria, investors often hope to make a more positive impact with their money.

While the exact meaning of ESG can differ by investor, the three main pillars include:

• Environmental: Sustainability efforts aimed at protecting the Earth and our natural environment or at least accounting for this risk, in areas such as emissions, air quality, waste management, land usage, and energy footprint.
• Social: A look at the company’s impact on people/society, such as on-site labor practices, safety standards, community outreach, and equal employment opportunities.
• Governance: A snapshot of the standards that leadership is held to ensure companies are managed well by boards and executives, such as in terms of ethical business practices, board diversity, reasonable executive compensation vs. employee pay, and overall transparency.

Despite all these bars to clear, ESG funds can be just as lucrative as traditional funds — sometimes even more so, as some believe that looking at these factors helps reduce risk, attract customers, retain employees, etc. However, ESG investing can be more complex and expensive, and there can still be a risk of underperformance, even if that’s not always the case.

Quick tip: You can invest in alternative, tangible goods like agricultural products, energies, and precious metals with the best commodity trading apps. Commodity investing can be a great way to hedge against inflation and further diversify your portfolio. However, these assets tend to be more volatile and complex. 

Why ESG investing matters

ESG investing has faced some backlash in recent years, but it’s still important to many individuals and institutions. Some of the top reasons to engage in ESG investing include:

Financial performance

The jury’s still out on this one, as it depends on exactly how you look at the issue, but many studies do show that companies with strong ESG practices have better long-term returns than companies that ignore or have weak ESG practices. 

For example, a company that has strong governance with a diverse board and reasonable executive compensation might be better suited to navigating challenging economic conditions — with diversity helping to avoid groupthink that leads to bad decisions and reasonable executive compensation preventing hostility between lower-level employees and management.

One piece of evidence is a McKinsey study that shows companies with strong ESG scores, alongside strong financial metrics, have higher total shareholder return than companies that just have strong financial metrics. Yet the study showed that strong ESG scores aren’t enough to compensate for lagging financial metrics.

Risk mitigation

Even if ESG factors don’t lead to better financial performance right away, many investors believe that it’s important to choose companies or funds that account for ESG factors in order to mitigate long-term risk. For example, the world could look very different in a few decades due to climate change, and the companies that are taking this risk into account might be better positioned to navigate issues like lower crop yields, supply chain disruptions, or population displacements. 

Making a better impact

Technically, “impact investing” is its own category of investing that is more clearly oriented toward investing in companies that produce positive benefits for the environment and/or society. In contrast, ESG investing might not have as much direct emphasis on doing good in the world, as it might just be about responding to risks, like waste leading to excess costs. Still, ESG investing generally overlaps with impact investing, as many companies with high ESG scores also make a more positive impact on the world than non-ESG-oriented companies.

Growing demand

Even if you don’t fully buy into the rationale behind ESG investing, it’s becoming more popular in many areas of the world. So from an investment standpoint, sometimes moving into areas of high demand is beneficial, as demand can lift asset prices. Of course, there are risks involved in chasing demand, but this is still a reason why some investors turn toward ESG.

How ESG investing works

While ESG investing is somewhat in the eye of the beholder, some common areas include:

ESG integration

As part of a traditional financial analysis, many investors incorporate ESG factors. For example, instead of just looking at financial metrics like profit margins and return on equity, ESG integration might involve looking at quantitative data like ESG scores along with qualitative data like a company’s ability to attract talent by marketing itself as a socially responsible company, which can ultimately help long-term growth.

ESG screening

Similar to ESG integration, ESG screening involves including or excluding companies based on ESG factors, like excluding any companies involved with fossil fuels or only investing in companies with top ESG scores from ratings companies like Morningstar, MSCI, Bloomberg, and Sustainalytics

Shareholder engagement

Institutional investors like some mutual fund companies participate in what’s known as shareholder engagement to try to influence companies to take ESG factors into account more. That can take a few different forms, such as filing shareholder resolutions that other shareholders vote on or meeting with boards to assess their commitment to accounting for ESG risks. Retail investors can theoretically engage boards and management too, but they generally have less power than large institutional investors to prompt change.

ESG investing strategies

There are a few different ways to engage in ESG investing, such as through:

ESG funds

Some mutual funds or exchange-traded funds (ETFs) are specifically geared toward ESG investing or related themes like clean energy. Some examples include:

• iShares Global Clean Energy ETF (ICLN) — tracks the S&P Global Clean Energy Index, providing exposure to companies pursuing renewable resources
• Vanguard FTSE Social Index Fund Admiral (VFTAX) — a social-oriented index fund that screens out companies that do not meet certain standards such as around labor and human rights.
• iShares ESG MSCI USA ETF (ESGU) — another index fund that’s based on exposure to companies with strong ESG ratings.

Other examples of ESG funds or related vehicles include:

• iShares MSCI USA ESG Select ETF (SUSA)
• Natixis Sustainable Future 2025 N (NSFEX)
• Shelton Green Alpha Fund (NEXTX)
• Vanguard ESG US Stock ETF (ESGV)
• Xtrackers MSCI USA ESG Leaders Equity ETF (USSG)

Sustainable investing platforms 

Some investment platforms or apps are specifically geared toward helping investors easily create ESG-oriented portfolios.

“An investor that holds socially responsible characteristics as their top priority when investing, and has a limited amount of time to conduct research on their own, should consider opening an account through a socially responsible investment app,” says Sandra Cho, RIA, wealth manager, and CEO of Pointwealth Capital Management. “For this type of investor, the fee for the platform is worth it, as the investor will save hours of time not having to do the research on their own.”

Some general robo-advisors like Betterment and Wealthfront still let you choose ESG funds, while more specialized platforms like Ellevest and SustainFolio are more directly geared toward ESG investing.

Although socially responsible investing apps offer an accessible way for investors to support ethical business practices and similarly related issues, it’s still in your best interest to research the institutions you’re investing in and ensure that their values align with yours.

Individual stock selection

Some investors prefer to allocate to specific companies, rather than funds. In that case, you could consider researching the ESG practices of various companies. You can use one of the best stock trading apps to select companies that align with the ESG areas you care most about.

However, keep in mind that you might not have as many data or analytics tools that ESG funds use. Still, you might find that you like a company’s mission, for example, and want to invest in their stock. Just be aware of the risks of individual stock picking, such as those that can come from a lack of diversification.

Challenges and considerations of ESG investing

While ESG investing offers many potential benefits, some possible pitfalls to consider include:

Data and measurement inconsistency

Not every company reports the same data, and ESG scores can be somewhat subjective, with variation among providers. ESG data is not always as clear-cut as certain financial metrics.

Greenwashing

Some companies exaggerate their ESG efforts, so it’s important to be cautious about taking companies at their word and instead try to dig into more concrete information, like hard numbers released in their annual impact reports or third-party verification of their efforts.

Performance

As mentioned, the jury’s still out on ESG investment performance, and at the very least there’s a risk of deviating from standard market averages, like the S&P 500. Performance can also be affected by short-term issues such as geopolitical conflicts that disrupt energy prices and political changes that affect environmental regulations, for example. Sometimes these changes help ESG-related companies while other times they create new risks.

Fees

ESG investing can also be pricier than traditional investing, such as with sustainable investing platforms charging a higher annual fee than standard brokerages.

“This fee covers the platform’s cost of research, analysis, and other operating expenses,” says Cho. “Compared to a standard platform that allows investors to open an account for free, this is a significant disadvantage.”

ESG investing vs. socially responsible investing

The terms ESG investing and socially responsible investing (SRI) are often used interchangeably in the investing space, and they do have a fair amount of overlap. For each strategy, investors make decisions based on social impact instead of rates of return alone, and both represent ways of making your voice heard as a socially conscious investor. 

While there’s no official delineation, SRI is often more values-driven. For example, if one of your passions is carceral reform and it’s revealed that a successful company exploits prison labor for its profits, you wouldn’t invest in that company no matter how high its profits soared, so you might choose an SRI fund that excludes these types of companies. 

With ESG, things are less black and white. The strategy is often based on a rating system, and while higher-ranked investments are preferred, some funds might still invest in some lower-ranked companies based on their financials and potential for ESG-related improvement.

FAQs about ESG investing