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What you need to know about ESG investing

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ESG investing is continuing to grow, here's what you need to know before setting up your own portfolio.

ESG investing is all the rage with shareholders looking to align their money with their morals.

And following the urgent need for climate action that came out of COP26 last year, it is unlikely to slow down anytime soon.

ESG or environmental, social and governance is about setting standards for how companies operate. Environmental criteria are based on how they interact with nature, social relates to their treatment of customers, employees and suppliers, while governance deals with leadership, executive pay and shareholder rights.

But for those new to investing or wanting to start an ESG portfolio understanding the ins and outs of the sector can be tricky.

As such we've spoken to industry experts to help you become a better ESG investor.

What is ESG investing?

ESG investing is simply prioritising more than just the financial performance of a business.

Instead, ESG investors look into a company's actions on environmental, social and governance outcomes and try to choose businesses that closely align with their own personal values.

But as Morningstar's ESG analyst Erica Hall notes, ESG investing is not black and white but shades of green. It's still a maturing industry meaning different things to different investors.

"Ultimately Sustainable investing incorporates investors' values with their investment decisions. The goal is to invest in a way that generates both long term value and makes a positive contribution to the planet," she told Finder.

As it currently stands, there is no clear yardstick to use as a benchmark with an estimated 200 ESG classifications currently being used by investors.

As such, an investor who is new to ESG can simply decide for themselves what products and areas they deem morally acceptable.

How to get started?

Building an ESG portfolio all comes back to you.

As mentioned earlier, ESG investing does not have a specific rule or plan to follow. Instead, it is all down to the individual investors and what they deem "ethical".

Some might prefer to focus on environmental issues and disregard social issues such as workers rights, while others might want to choose companies with a strong record of workers rights but are less concerned with environmental issues.

An easy way to start is by positively or negatively screening.

That is when an investor chooses the things they like or dislike and actively adds money to the companies they have positively screened while refusing to invest in companies they have negatively screened.

According to Tribeca's portfolio manager Jun Bei Lui, investors are becoming more sophisticated when it comes to ESG investing.

"In terms of the focus in Australia, we've always had an environmentally focused investor base. Now what's interesting is that governance and social has risen. Governance grew during the GFC and then this pandemic has really increased intensity for both governance and social as it's a crisis in our society," she said.

Before building their portfolio, an individual will also have to decide whether they want to allocate 100% of their resources to ESG investing or just dip their toe in it.

Once an investor has worked out what they believe in and how much they want to invest they can start building a fund.

Bei Lui explains investors so far have been playing it by following the hot stock, but this has its own risks and rewards.

"These are the likes of Lithium or circular economy or things to do with processing battery material, all of these spaces have been very buoyant over the last few years," she said.

ESG investing ideas

To help investors get started, Hall highlights the "low risk" from an ESG perspective sectors including IT consulting and infrastructure software.

"A couple of examples of those that have low ESG risks are Accenture and SAP," she said.

Looking to Australia, Hall points to "Afterpay which does pretty well from a risk perspective and Brambles also has low risk".

When it comes to medium risk, companies like Telstra come up, while high risk companies include Amazon and Ampol oil and gas.

According to Bei Lui the healthcare sector, especially for social investors, might be a good place to start.

"Healthcare is a place worth looking at. Generally, [in Australia] we have world leaders. I think this is a sector that has a lot of good buying opportunities and these are the structural growth leaders that will deliver growth year in year out," she said.

To see a list of the previously most 10 traded ESG companies click here.

Risk and rewards

At a glance, ESG investing appears less risky.

After all, companies that are doing the right thing generally avoid scandals, helping to protect their share price.

However, ESG comes with it’s own set of risks and restrictions. After all, investors are either including or excluding a bunch of companies. Either way a smaller investing universe means fewer options and that you have to pay more for quality ESG companies.

“When you talk about quality, how much do you pay for it?,” Bei Lui said.

“We do see a bit of a bubble forming in some of those concept stocks, companies don’t yet make money from these [ESG] technologies, making them very risky, yet their share prices have gone up,” she said.

Despite the risk in some stocks Bei Lui sees a positive outlook for ESG investors.

“I think the amount of IPOs and new businesses, we certainly see a lot more companies coming available and in the next 12 months we will see an explosion in listing,” she explains.

Set up for a longer-time horizon

Despite some booming parts of the sector, if you're investing in ESG companies you might need to set a longer time horizon.

"Wind and solar are great, but they take time to transition. In between, we will have shortages. So I think it is important to have some of those new technologies in your portfolio but just be mindful about chasing sectors because the valuations could be incredibly high," Bei Lui said.

Bei Lui explains that ESG investors have to take a longer-term view because of this transition.

"It will take years to come through. If you're a disciplined investor you'll use sell offs as your entry opportunity.

"But the trick is, do we know enough about these businesses to know they'll still be around," she said.

Watch for greenwashing

As a reminder to investors, Hall urges them to watch out for greenwashing when setting up their ethically based fund.

Environmentalist Jay Westerveld coined the term "greenwashing" in 1986 in a critical essay inspired by the irony of the "save the towel" movement in hotels.

But essentially it is when a company spends more time and money on marketing themselves as environmentally friendly than actually minimising their impact on the world.

And while more investors become conscious as to what they are investing in, companies are trying harder to show they are green.

However, not all greenwashing is simply due to corporations trying to take advantage of investors.

"Whilst greenwashing is generally seen as intentional, occurring when asset managers oversell their green credentials, sometimes greenwashing may not be intentional resulting from differing definitions of sustainability and expectation mismatches between investors and the specific approach used by a sustainable fund," Hall notes.

"This is why it is important for investors to understand what they are buying (and what they want/what matters to them)."

Stakeholder capitalism driving future returns

At a certain point all investors will have to think about ESG investing, as it is simply the way the world is going.

BlackRock CEO Larry Fink used the term "stakeholder capitalism", a movement that is not about politics or ideology but being about capitalism with all stakeholders needing to benefit from the process.

The CEO notes "In today's globally interconnected world, a company must create value for and be valued by its full range of stakeholders in order to deliver long-term value for its shareholders.

"It is through effective stakeholder capitalism that capital is efficiently allocated, companies achieve durable profitability, and value is created and sustained over the long-term," he said.

As such, BlackRock suggests the rules are changing; for a sustainable investor, how companies grow shareholder value matters as much as the profit itself.

If you're looking for more information about ESG investing, see our how to ethically invest guide here.

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