Environmental, Social and Governance (ESG) investing has come into the limelight since President Biden used his first veto to allow employers to offer ESG investments in their 401(k) plans. Socially-conscious investing has grown in popularity in recent years, and by 2026, it’s predicted that nearly $40 trillion in assets under management will be invested with ESG funds.
For some, this is an exciting prospect, but others are more apprehensive and confused about ESG funds. No matter where you fall on that spectrum, it’s important to have a clear understanding of how this legislation may or may not affect your retirement savings.
What are ESG funds?
ESG funds are investment vehicles connected to companies scoring high on environmental, social and governance metrics. These funds are meant to align investments with investors’ personal beliefs and values. They can take many forms, including mutual funds, exchange-traded funds (EFTs) and separately managed accounts.
ESG funds have been around since the 60s. Originally, they were created to help people avoid investing in companies that did not align with their morals, which included industries such as tobacco, guns and alcohol. Although ESG funds can still serve this purpose, many modern investors use ESG metrics to invest in companies committed to being environmentally conscious, socially responsible and ethical. ESG compliance is measured using several criteria: The environmental score is measured by fossil fuel consumption. The social score is determined by any human rights violations and if a company is involved in industries related to weapons or tobacco. The governance score is measured by female board representation, diversity and pay performance links.
How do ESG funds affect my 401(k)?
Investors with Roth IRAs, traditional IRAs or any other retirement savings vehicle can choose whether or not to use ESG investing. But many are concerned about how the new regulations around ESG funds might affect their employer-sponsored 401(k). Under current legislation, no one is required to use ESG funds. Rather, employers are allowed to use ESG funds so long as it is still in the best interest of the participants. However, they use a wide variety of criteria to decide what kinds of funds to offer in their 401(k) plans, such as investment performance, diversification, fees, risk levels and regulatory (legal) requirements.
If your employer offers ESG investing opportunities, you can choose to participate in those funds or not. If your employer doesn’t offer ESG funds or use ESG as a criteria, and you want the option, consider advocating to your HR department or use ESG investing for your non-employer-sponsored accounts, like a Roth IRA.
Benefits of ESG Investing
ESG funds can help socially and environmentally-responsible investors integrate their personal values with investments. Some studies suggest that companies with high ESG scores may outperform those with low scores in the long term because of better risk management, innovation and stakeholder engagement. Plus, ESG funds are less exposed to regulatory and reputational risks that can impact companies in controversial industries, like tobacco. The growing popularity of ESG investing may boost the value of ESG-compliant companies as it becomes more mainstream and more consumers start to support companies in alignment with their values and beliefs.
Drawbacks of ESG Investing
Despite its advantages, ESG investing can limit the number of companies and industries investors have access to. ESG funds may exclude companies that perform well financially but score poorly on ESG metrics, making it harder to stay diverse and potentially lowering returns. Plus, there’s currently no standardized approach to measuring ESG performance, which makes it difficult to compare funds and assess their social and environmental impact. With additional research and screening required to determine ESG compliance, some ESG funds may have higher fees than traditional funds.
Should I be using ESG funds?
It’s possible to create a solid retirement savings using ESG investments, so if you are especially concerned about social and environmental impact, consider ESG investing. However, to help ensure diversification, consider a wide range of ESG funds that span asset classes and investment styles. For example, you might choose to invest in a mix of ESG mutual funds or EFTs that focus on stocks, bonds and real estate investment trusts (REITs). It may also be helpful to consult a financial advisor experienced with ESG investments to help navigate all your options.
Use careful consideration around ESG funds because they carry risks, and returns are not guaranteed, which is true of any investment! Deciding to use ESG funds or not depends on your unique financial situation, including your individual goals, personal values and investment risk tolerance.
While social and environmental issues can feel personal and emotionally charged, investors should not let their emotions drive their decisions. It’s important to approach every investment decision with a clear and rational mindset, accounting for a range of factors beyond just your personal values.
One way to make socially-responsible decisions without letting your emotions take control is to use a systematic approach that incorporates objective criteria for evaluating potential investments. For example, consider a company’s financial performance, governance practices, social and environmental practices in addition to its alignment with sustainability standards.
Making sound investment decisions, ESG and otherwise, takes careful consideration and experience. We help our clients work through all their options, and for those passionate about supporting socially-conscious companies, we have the capabilities to analyze investments for ESG criteria. We can build portfolios around one or more aspects of ESG investing, depending on what’s most important to you.
If you have questions about ESG investing, schedule a meeting at zephyrusfs.com. As independent fiduciaries, we take the time to get to know our clients to understand what is best for their money. Some people want their investments to align with their personal beliefs, while others simply want to focus on growth and security. We get to know what each and every one of our clients is about before making any investment suggestions because you deserve a financial plan that aligns with your unique goals.
ESG investing involves the exclusion of certain securities for nonfinancial reasons. This may result in the investor forgoing some market opportunities that may have been available to those not subject to such criteria. There is no guarantee that any investment goal will be met.