By Stuart Lane, CEo, Trade Nation – https://tradenation.com/

‘Money’ and ‘ethics’ are two concepts that historically haven’t been closely aligned. For many, money represents excess, materialism and greed, symbolised by big-name corporate brands that are hugely successful, yet this success is often a result of unscrupulous activities. However, there has been a clear shift towards a more socially conscious approach to money in recent years. Consumers are now far more motivated to do business with organisations in line with their own morals and values, and this tendency could become even more common in the wake of coronavirus. If consumers are keen to put their cash towards ‘ethical’ companies working to make the world a better place, it stands to reason that investors would like to do the same.

This is where ESG trading comes in, which stands for environmental, social and (corporate) governance. While investors would once hope to make big bucks by backing morally questionable industries like tobacco and defence, there’s now a growing interest in businesses that aim to positively impact the planet by championing sustainability and corporate responsibility.

This sounds ideal at face value — companies have more of an incentive to be fair, transparent and considerate in everything they do, while investors know their money is having a positive impact. But is ESG trading as brilliant as it seems, or is this trend more about virtue signalling than making rational investment decisions?

The difficulty defining an ESG

The three aspects of ESG can be broadly defined as follows:

• Environment: Measures a company’s carbon footprint, greenhouse gas emissions and climate change policies.

• Social: Covers company culture and issues impacting employees, customers, suppliers, and wider society.

• Governance: Concerns regarding how a company is managed. A strong board of directors will relate well to the company’s stakeholders, run the business well, and align the management team’s incentives with the organisation’s success.

However, it is very difficult to say that a stock is wholly ethical. Take Tesla, which is full of contradictions. On the one hand, it is an electrical vehicle manufacturer which clearly has environmental benefits. On the other hand, the company relies on lithium and cobalt to create its batteries — earth metals mined at environmental and human cost. It’s hard to identify companies that are outstanding in every area.

The greenwashing effect

Some aspects of an ESG can be properly measured and certified but others can’t. The problem is that many companies claim they are working towards wholesome-sounding ‘goals’ but fail to provide hard evidence. While it may be tricky to track down, those keen to invest in ESGs can find data prepared according to respected sustainability standards, like the Global Reporting Initiative (GRI) and the United Nations Principles for Responsible Investment (PRI).

Ultimately, it’s incredibly important to examine a company’s track record when they comment on things like their commitment to mitigating climate change or how well they take care of their employees. Given how popular ESGS are with consumers and investors alike, expect to find a lot of organisations exaggerating their credentials rather than putting meaningful work in when it comes to the environment and other ethical issues.

ESGs and profitability

As nice as it is to support companies doing great things for the planet, investors aren’t going to be so keen if it means their potential profits could take a hit. At the end of the day, while supporting a business making a positive impact may be good for the investor’s reputation, its ESG record has to be weighed up alongside its financial performance. Luckily, it looks like lots of companies can excel on all fronts. Fidelity’s Putting Sustainability to the Test report (published in November 2020) found ESG-linked stocks had better returns than those with lower ESG ratings in almost every month from January to September.

“Overall, we’re pleased to observe the relationship between high ESG ratings and returns over the course of a market collapse and recovery, supporting the view that a company’s focus on sustainability is fundamentally indicative of its board and management quality,” Fidelity stated. In addition, stocks with high ESG ratings appeared to be less volatile, and therefore help reduce portfolio risk. “The groups with higher ratings fell less as the markets collapsed and rose less when they recovered sharply in April than those with lower ESG ratings. This suggests that those stocks with higher ESG ratings also have a low beta, high quality factor and are less prone to volatility in the broader market.”

Is ESG investing a good idea?

Fears over climate change and increased public awareness about ESG issues like workers’ health and safety mean that investors are now much more likely to consider the impact of their money on the whole. While many are merely jumping on the bandwagon, in truth there is very little to dislike when it comes to ESGs. As well as investing ethically and helping preserve the planet, there are still lots of opportunities to profit handsomely. It really is the best of both worlds.

That said, investors also must do their research and perform due diligence to make sure the companies or ESG-compliant funds they’re looking at really are what they seem. As previously mentioned, it’s near-impossible to find stocks that perform well for every aspect. ESG investing is open to different interpretations, so the best investors can do is prioritise the areas most important to them and seek out companies that genuinely align with these issues.