Your complete guide to investing with a conscience, a $30 trillion market just getting started

Key Points
  • ESG investing — or strategies that take a company's environmental, social and governance factors into consideration — grew to more than $30 trillion in 2018, and some estimates say it could reach $50 trillion over the next two decades.
  • These strategies, which include impact investing, are not new, but momentum is growing as shareholders demand action, and as the consequences grow for companies that fail to adapt.
  • One of the most popular ways to evaluate these metrics is through ESG integration.This is a strategy whereby a stock is evaluated through an ESG lens alongside traditional metrics like capital allocation and cash flow.
  • There are a number of ways to take an ESG-style investing approach, including ETFs that track indices, as well as specialty funds that do not include stocks related to polarizing areas of the market such as tobacco and fossil fuels.
  • Once thought to come at the expense of returns, ESG strategies have proven that they can be market-beating.

(This story is part of the Weekend Brief edition of the Evening Brief newsletter. To sign up for CNBC's Evening Brief, click here.)

ESG investing — or strategies that take a company's environmental, social and governance factors into consideration — grew to more than $30 trillion in 2018, according to Global Sustainable Investment Alliance, and that number is set to keep rising as consumer tastes shift and investors demand more transparency. Once a niche approach thought to come at the expense of returns, these strategies have proven that they can be market-beating. And as investor momentum builds, some argue that companies can no longer afford to discount their ESG ratings.

Definitions of "ESG" are wide-ranging. The inherently subjective nature can make these factors hard to quantify — my good could be your bad.

Putting that aside, here we'll take a look at the evolution of ESG investing — what's behind the drive, especially as millennials and Gen Z take over the workforce, and the very real implications for companies that do not act. We'll also consider some of the most popular ESG strategies, including ways in which investors can buy into the socially responsible investing movement.

ESG is already big, and it's only growing. According to predictions from Bank of America, another $20 trillion is set to flow into ESG funds over the next two decades, which the firm called a "tsunami of assets." For context, the entire S&P 500 is worth about $25.6 trillion.

These strategies are not new. The term "ESG" was coined in 2004 and the idea of investing with a broader goal in mind has been around for decades. But while taking this approach was once an exception, it's now becoming the norm. More than 2,250 money managers who collectively oversee $80 trillion in assets have now signed on to the United Nations-backed Principles for Responsible Investment.

Traditionally some argued that taking this approach could mean sacrificing returns. But research suggests otherwise. There's no shortage of ways in which to enact an ESG style, but perhaps the most basic approach — buying ESG-focused ETFs that track indices — have shown to yield returns similar to their benchmarks. Nuveen ESG Large-Cap Growth and iShares ESG MSCI USA are such examples. Both are beating the S&P 500 this year.

"This is not in any way concessionary to returns. We actually think it's going to improve returns because it's going to help us select better companies to invest in," said Cliff Robbins, founder of $2.2 billion hedge fund Blue Harbour Group, at "Delivering Alpha" in September. "I think it's so powerful. I'm telling public company CEOs that I'm investing in today that three years from now their P/E is going to be affected by their ESG rating."

Within sustainable investing, styles range from ESG integration, to socially responsible investing to impact investing. Put simply, the primary factor in ESG integration is still financial performance, while impact investing is meant to maximize, with a quantifiable impact, societal reach. Socially responsible investing is somewhere in the middle.

Different reasons fuel investors' appetite for ESG strategies. Some do it for moral reasons, choosing to completely shun companies that do not align with their views. Others, and the majority, consider ESG factors from a financial risk standpoint. For example, if a company doesn't employ equal pay practices, there could be backlash and a high turnover rate which could, in turn, impact the stock performance.

But as these strategies gain popularity so, too, do the issues surrounding this approach. For one, it can be difficult to assign an ESG "score" to a company since many of the factors like brand appeal, for instance, are subjective. It can also be hard to prove that ESG is, in fact, being integrated into investment divisions. And some say that while ESG can weed out bad behavior it's not sparking innovation and moving the ball forward on things like climate change.

While there might be an array of approaches to ESG investing on the Street one thing is certain: it cannot be ignored.

Sustainable investing surge

If sell-side research from Wall Street firms is any indication of market sentiment, investors are really interested in ESG. Analysts are devoting more and more pages to ESG strategy reports, and many firms are integrating ESG analysis into their regular research notes.

"ESG … looks set to dominate investors' agendas in the years ahead," Credit Suisse said in a recent report, and Bank of America said that "70% of US assets can't be analyzed without using ESG."

"As ESG issues become increasingly material across many industries, our GS analyst teams have taken pen to paper to address the impact on corporates," Goldman Sachs analysts said in November.

"The demand for Sustainable Investing has been clearly growing over the past year," JPMorgan noted.

As investors' interest has spiked, the Street has taken note. New ETFs and mutual funds focused on ESG strategies have launched in record numbers, and there are a number of different ways for investors to deploy their capital in ESG strategies.

According to data from Morningstar, this year, through the end of November, $17.76 billion flowed into sustainable-focused ETF and open end funds available to U.S. investors. Last year's total inflow reached $5.5 billion, which was then a record high. 2019's number has already tripled that, and the year isn't over.

"Increasingly proactive, they [individual investors] seek products and solutions across asset classes tailored to their interests. They also want to measure the environmental and social impact of their investments," Morgan Stanley said in an Institute for Sustainable Investing report.

Rising, not necessarily risky, returns

One of the initial criticisms against ESG investing was that it meant compromising on returns. Of course, if you limit your options you could potentially sacrifice financial performance.

But the data tells a different story. 65% of sustainable funds rank in the top half of their respective Morningstar category through November, the firm said, and 48% of large-cap blend sustainable funds are beating the S&P 500 this year. By comparison, overall only 26% of large-cap blend funds are beating the market.

The longer-term figures show a similar trend. Morgan Stanley analyzed the performance of nearly 11,000 ESG-focused funds from 2004 - 2018, using data from Morningstar, and found that performance was comparable with that of their non-ESG focused peers.

"The returns of sustainable funds are in line with those of traditional funds, while also offering lower downside risk for investors," the firm said in its Sustainable Reality report. "What's more, in an uncertain market, sustainable funds may offer a layer of stability for investors looking to reduce volatility."

ESG Strategies

There are many ways to incorporate ESG strategies into a portfolio, and one thing that just about everyone agrees on is that there's not a "one size fits all" approach.

According to the Global Sustainable Investment Alliance, negative and norms-based screens are among the most common approaches. The first one means avoiding one category of stocks entirely — tobacco, for instance — while the latter is based on compliance with international standards established by organizations like the OECD or the United Nations Global Compact.

ESG integration is another popular method that's gaining steam. This is when an investor takes into consideration a company's ESG profile — and any potential risks — as one of the evaluated factors when considering whether or not to buy a stock. This analysis can be done independently, and then there are also a number of agencies that provide research and issue ESG "scores."

ESG-focused shareholder activism is another approach that's gaining traction, particularly as investors call on the country's largest investment management firms — sometimes a company's largest shareholder — to push for change.

Generally speaking, the first priority for ESG integration strategies remains financial performance, while impact investing's focus is the greatest possible societal reach. This latter form of investing can be difficult for individual investors to access through the public market.

Morningstar's head of sustainable research Jon Hale said that he's seeing large inflows into diversified sustainable funds, or funds that could be substituted for an investor's conventional holdings. These funds track indices like the S&P 500 or the Russell 2,000, but an ESG evaluation is central to the fund's security selection process. Factors like a stock's weighting, for example, could differ from the benchmark.

Examples of this type of fund, all of which are beating the S&P 500 this year, include: Nuveen ESG Large-Cap Growth (NULG), ClearBridge Sustainability Fund (LCISX), UBS US Sustainable Equity Fund (BPEQX), Aspiration Redwood Fund (REDWX) and Calvert Equity Fund Class (CSIEX).

Hale said there's been an especially noticeable increase in money going into sustainable fixed income funds, in part because a number of new funds have launched. "More investors I think are starting to understand that they can use ESG funds, sustainable funds across their entire portfolio," he said to CNBC.

In some smaller areas of the sustainable investing landscape funds are posting returns far ahead of the market. This is especially true of some renewable energy-focused funds. Invesco Solar (TAN), Invesco WilderHill Clean Energy (PBW), ALPS Clean Energy (ACES), SPDR S&P Kensho Clean Power (CNRG) and Shelton Green Alpha (NEXTX) have all returned more than 40% this year.

It is important to note, however, that these funds can be volatile. While Invesco's solar fund has surged 60% year-to-date, it ended 2018 with a 26% loss.

Picking a sustainable portfolio

When it comes to evaluating specific stocks, things can get tricky. There are some companies that obviously fall into either the "E," "S" or "G," but the holistic picture might be harder to judge.

ClearBridge Investments portfolio manager Derek Deutsch said that he looks for companies that are "best in class" with "very strong sustainability profiles."

"We want companies with sustainable competitive advantages, and that would include excellent corporate governance, and companies that treat their employees well, interact in a positive way in communities where they're located, etc.," he said to CNBC.

Ball Corporation and Trex Company are among the holdings in the ClearBridge Sustainability Fund that Deutsch manages.

The former is a Colorado-based manufacturing company which, among other things, makes aluminum beverage cans. Demand for aluminum is growing since it's a much more sustainable material than glass or single-use plastic. Deutsch said that the company's seen volumes double, driven in part by rising sales from carbonated drinks and craft beers. The stock has gained 38% this year. "We think this is going to be a secular trend because everyone is concerned about these issues," he said.

Trex Company, the fund's fifth largest holding, makes house decks from recycled plastics. The stock has gained 50% this year as the company takes market share from traditional lumber manufacturers. Deutsch said he believes the company can double earnings in the next 3-5 years.

ClearBridge Sustainability Fund has an ESG mandate, so it might come as a surprise that the top four holdings are Microsoft, Apple, Alphabet and Costco. Deutsch said that part of what they consider when determining whether or not a stock belongs in the fund is the societal impact of the product or service that the company offers.

When it comes to top-holding Microsoft, for instance, he said there are a number of factors that make it a "sustainability leader," including their productivity-enhancing software. He also noted that the company has been progressive on a number of social fronts, and that they've pushed to source energy from renewable sources.

This particular fund has no exposure to any company that's primarily engaged in fossil fuel extraction or mining, although other funds at parent company Legg Mason, which has $790.5 billion in assets under management, could have exposure to traditional oil companies.

ESG analysis is also playing a greater role in sell-side research from Wall Street analysts.

For instance, DA Davidson said that TJX, Lyft, Etsy and Synovus are among the buy-rated stocks in their coverage universe that look best from a governance standpoint. In a recent report JPMorgan said its top alternative energy picks going into 2020 are First Solar, SolarEdge and Sunnova Energy as investors pivot to cleaner sources of energy.

Taking a more thematic approach, Credit Suisse said the most attractive areas within sustainable investing are education, future of work and healthy living. Based on this, they scanned their analyst coverage looking for outperform-rated companies that fall into these categories, and found that Informa, Honeywell, Stryker and VF Corporation are among the companies that look best from this standpoint.

What's driving the surge?

The key driving factor behind the surge in ESG investing is most probably investors' demand for clarity when it comes to a company's stance on social issues, as well the significant financial consequences that a company can face if it fails to adapt to changing consumer behavior.

Europe has traditionally been a leader when it comes to ESG, and a new wave of regulation is set to accelerate how investment managers account for ESG factors. But the United States is catching up.

"Unquestionably we are seeing more ESG demand worldwide and probably the biggest net changes in demand in the U.S.," BlackRock Chairman and CEO Larry Fink said on CNBC's "Squawk Box" in 2018.