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What is ESG investing? A beginner's guide to choosing a sustainable fund

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So-called ESG investing is a big deal. The acronym applies to investment strategies that take environmental, social and governance factors into account, and these days serves as a stand-in for all strategies marketed as sustainable investments.

By year-end 2022, following broad declines in the stock and bond markets, investor assets in sustainable investments amounted to $8.4 trillion, or about 12.6% of all U.S. assets under management, according to the Forum for Sustainable and Responsible Investment (US SIF).

In other words, 1 in every 8 U.S. investor dollars is in a sustainable fund.

The growing prominence of and demand for ESG investments has attracted the attention of politicians and regulators. Last month, President Joe Biden used his first veto to preserve a Department of Labor rule allowing employers to select ESG options for their 401(k) plans.

Meanwhile, politicians in Texas and other states have put measures in place to ban fund companies they see as "boycotting" energy companies from doing business with the state. Critics have even decried ESG strategies as needlessly "woke."

All of which raises a couple of important questions: What are ESG investments exactly? And what role could they play in your portfolio?

What is an ESG fund?

ESG has become a catch-all acronym for what asset management industry pros would call sustainable investing — strategies that seek to deliver a financial return while providing for societal good.

If that sounds like a broad definition, it's because it is. Under the sustainable umbrella you'll find strategies that remove a few "bad actor" companies from otherwise broad indexes, as well as funds that invest in companies they see as furthering a particular environmental goal, such as providing clean water.

"Hopefully, we'll start to see asset managers become more intentional with branding to improve public understanding and, in turn, help the investor," says Alyssa Stankiewicz, associate director of sustainability research at Morningstar.

To that end, the SEC proposed regulations last year which would force stricter rules surrounding sustainability fund names, theoretically making it easier to understand what a particular fund holds.

In the meantime, you'll have to do a little homework. For starters, sustainable funds generally fall into three major buckets:

1. Socially responsible funds

Socially responsible investing (SRI) strategies have been around since the 1950s and tend to be more about what a fund doesn't own than what it does.

Such funds may own a broadly diversified portfolio, but will eschew investing in firms with significant revenues from controversial industries. Early on, these were often alcohol, gambling and tobacco. More recently, funds have begun excluding industries such as firearms and fossil fuel production.

2. ESG funds

This is where conflating ESG funds and "boycotting" the energy industry gets a little spurious.

Funds with an ESG framework typically seek to invest in companies that score highly on environmental, social and governance criteria. That typically means they're working to reduce their environmental impact, treat employees and customers well, value corporate diversity and align their policies with the interest of shareholders.

Failure to account for these factors, ESG proponents argue, represents a threat to the viability of a company's business.

"Climate change, racial justice, diversity, equity and inclusion — these are all financial metrics because your workforce is part of whether your business can succeed or not," says Andrew Behar, CEO of sustainable investing research firm As You Sow.

3. Impact funds

In general, "ESG is about risks to a company's valuation, not about what it does for the community. It's not about providing solutions for climate transition," says Stankiewicz.

Those types of funds are impact funds, which seek to create tangible progress toward sustainable goals. Morningstar divides these funds into five buckets:

  1. Climate action
  2. Healthy ecosystem
  3. Resource scarcity
  4. Basic needs
  5. Human development

While an ESG fund might reward firms with low carbon footprints, for instance, a climate impact fund might invest in firms that manufacture solar panels or wind turbines.

How to decide on a sustainable fund

If you're interested in adding a sustainable investment to your portfolio, ask yourself why before you buy.

If it's about making money or protecting against risk while investing in line with your values, you may favor an ESG fund. If you can't stomach the thought of contributing to a certain kind of firm, you may seek an SRI fund. If you're looking to "do no harm" or make a difference with your investments, you may want an impact fund.

Even if you know what you have in mind, you may still want to do a little digging. Until the SEC's rules kick in, a mutual fund's name needs to align with only 80% of its holdings. That's prompted some firms to say, "Oh, we can call it a fossil-free fund and we can be 19% coal," says Behar.

Some free online tools can help you find a fund or look under the hood of one you may be interested in. Here are two to check out:

  • Morningstar's ESG screener lets you sort funds by Morningstar's overall ESG rating (from one to five globes), as well as its stated investment objectives and involvement in certain industries.
  • As You Sow's Invest Your Values tool allows you to search any fund and read a report card on factors such as fossil fuel exposure, gender equality and investment in private prison operators.

But remember, before choosing any investment on its sustainability criteria, you still need to make sure it's a good fund that fits your investment goals.

"ESG isn't going to be a silver bullet to outperformance for a bad manager or an impediment to a strong manager," says Stankiewicz. "It's always important to look at the fundamentals of a fund you're considering buying."

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