The introduction of ETFs in the 1990s is an example of how markets and their regulators respond to investor interests. When ETFs were first introduced, they were based on broad market indexes that were widely known and used by investors. As the years have gone by and investors have become more familiar with ETFs and how they may be used in portfolios, ETF issuers have continually tried to tailor new ETFs to address investors’ increasingly targeted interests. This is particularly true for environmental, social, and governance (“ESG”) investing.

Investor interest in doing good while doing well in their investments is growing. According to a report published by SSGA last year, total ESG assets under management worldwide were estimated to be nearly $22 trillion (see graphic below). It is for that reason that we are seeing an increasing number of ETFs being issued with an ESG focus.

Total ESG Asset Under Management, Invest With An Edge

In any discussion on this topic it is important to understand that ESG is a catch-all phrase, not a term with a single definition. Also, it should not be confused with the term “green,” which deals almost exclusively with the “E” component of ESG.  Going beyond the common green label, the environmental component includes consideration of energy use, energy efficiency, pollution risk, natural resource conservation, and animal abuse, to name a few.

The “S” (social) component of ESG includes things like a company’s efforts to select suppliers with effective and improving ESG efforts, their contributions to the communities in which it operates, whether they allow their employees to take time off to volunteer in their communities, and whether a company maintains a healthy, safe, and good work environment for its employees.

The “G” (governance) component deals with a company’s transparency in policies, practices, and accounting. Also considered are its diversity of employees and leadership, inclusion of stockholders in corporate policy making, and avoidance of conflicts of interest among its board members.

As one can see, ESG is a far-reaching set of criteria by which companies may be evaluated. As a result, there are a number of firms that evaluate and score companies on the basis of their ESG qualities. One way this can be done is via an exclusionary process whereby a company can “fail” an ESG evaluation by doing any of a particular set of actions, or by not doing another set of actions. Another approach growing in popularity is to create an ESG score based on a company’s efforts from a sustainability perspective.

One way this is done is by scoring a company with positive points for ESG actions that are supportive to its sustainability score, and deducting points for actions that are detrimental to its sustainability score. This method allows each company to be ranked within its industry, economic sector, or the market as a whole, and gives credit to companies for their efforts to improve their sustainable score and rank.

All of that is fine, but how does an ETF get an ESG score? Well, one way to do this is to take each of the holdings in the ETF portfolio, weight each of the individual holdings’ score by the weight of the position in the portfolio, and sum up those weighted scores. While this seems simple enough, the challenge comes in determining which method of scoring is used for each company in the first place. Remember, I said there are a number of methods of scoring companies on the basis of their ESG efforts. The standard will develop over time as ESG investing interest grows.

The question for investors, then, becomes one of knowing how to incorporate ETFs that use ESG factors into their portfolios. Of course, this depends on how important such factors are to each investor. For example, an investor could choose to craft their portfolio allocation as determined by their risk tolerance and then use, when available, ETFs that meet the allocation parameters PLUS have an attractive ESG score or rank. A more strict method would be to consider only ETFs that have an attractive ESG score when crafting the allocation. In either of these approaches, the definition of an attractive ESG score or rank is left to the discretion of each investor.

When thinking of ESG scores for companies, it is easy to assume that this factor only applies to stocks, but that is not true. A company’s ESG score is as applicable to their bonds as it is to their stock. Furthermore, it can also be used in scoring non-U.S. firms when data is available. The argument has been made in the past that using strict “green” screening criteria for companies and funds when building a portfolio limited a portfolio’s ability to diversify and, therefore, to perform well in ever-changing market conditions. The days of having to give up performance in order to promote and encourage positive ESG policies and practices within your portfolio are largely a thing of the past. For example, below is a 5-year graph that compares a balanced fund with an average of 254 stock and bond sustainable mutual funds. Using ESG scores and rankings enables investors to do good, while doing well with their investments.

Mutual/Index Fund Chart, Invest With An EdgeDisclosure: Author has no positions in any of the securities mentioned and no positions in any of the companies or ETF sponsors mentioned. No income, revenue, or other compensation (either directly or indirectly) is received from, or on behalf of, any of the companies or ETF sponsors mentioned.