ESG Investing Explained: What It Is, What It Costs, and Whether It Works

ESG investing has gone from a fringe concept to one of the most debated topics in finance. Proponents argue it's both ethically sound and financially smart. Critics call it a marketing exercise with questionable impact. The reality, as usual, is more nuanced than either camp admits.

Here's a clear-eyed look at what ESG actually is - and what it means for your portfolio.

What ESG Stands For

E - Environmental How a company manages its impact on the natural world:

• Carbon emissions and climate strategy
• Water usage and waste management
• Land use and biodiversity impact
• Supply chain environmental practices

S - Social How a company manages relationships with people:

• Labor practices and employee treatment
• Supply chain working conditions
• Data privacy and customer protection
• Community impact and diversity/inclusion policies

G - Governance How a company is run:

• Board structure and independence
• Executive compensation relative to performance
• Shareholder rights
• Accounting transparency and audit quality

How ESG Ratings Work (And Why They're Imperfect)

ESG ratings are produced by specialized firms: MSCI, Sustainalytics, Refinitiv, S&P Global, and others. Each uses its own methodology to score companies across hundreds of data points.

The problem: ESG ratings from different providers often disagree substantially.

Research published in the Review of Finance found a correlation of only about 0.5 between major ESG ratings providers - far lower than the near-perfect correlation between credit ratings from Moody's and S&P. Two raters can look at the same company and reach very different conclusions about how "ESG-friendly" it is.

This happens because:

• They weight categories differently (some prioritize environment, others governance)
• They define metrics differently (what counts as "good" labor practices?)
• Companies self-report much of the data, with inconsistent standards

The takeaway: an "ESG fund" is only as good as the rating methodology underneath it. Two ESG funds can have very different holdings.

ESG Fund Types

ESG exclusion funds: Start with a broad index and remove companies in certain industries (tobacco, weapons, fossil fuels, gambling). Straightforward and transparent.

ESG integration funds: Score all companies on ESG factors and overweight high scorers, underweight low scorers. Keeps broader market exposure but tilts.

Best-in-class funds: Select the top ESG performers within each sector, including energy and defense. Argument: encourages improvement within industries rather than abandoning them.

Impact funds: Target investments with specific measurable social or environmental outcomes - green bonds, affordable housing projects, sustainable agriculture. More direct, often less liquid.

Thematic funds: Focus on specific themes like clean energy, water infrastructure, or gender diversity. High concentration risk.

The Performance Question

Does ESG cost you returns? The data is genuinely mixed.

The case that ESG doesn't hurt (and may help):

• Companies with strong governance tend to have fewer accounting scandals, lawsuits, and regulatory fines
• Climate risk is increasingly priced into valuations - fossil fuel heavy portfolios may face stranded asset risk
• Strong employee practices correlate with lower turnover and higher productivity
• A 2022 meta-analysis covering 2,200 studies found that ESG factors had a positive or neutral effect on returns in the majority of cases

The case that ESG creates drag:

• ESG funds often exclude sectors (energy, defense, materials) that can outperform in certain cycles - energy was the top S&P 500 sector in 2022, a terrible year for most ESG funds
• ESG funds tend to be tilted toward tech and large-cap growth - so their strong performance in the 2010s may have been factor performance rather than ESG specifically
• Higher expense ratios compared to plain index funds (though this gap is narrowing)

The honest summary: ESG performance has been highly variable by period and methodology. Long-term evidence doesn't support a strong systematic advantage or disadvantage over plain indexing - but specific periods can look dramatically different.

What ESG Investing Actually Changes

A genuine criticism of ESG investing: does buying ESG stocks in the secondary market actually affect corporate behavior?

When you buy an ESG ETF, you're buying existing shares from another investor - no money goes to the company directly. The mechanism for influence is indirect: higher ESG scores may reduce a company's cost of capital, and strong ESG preferences could theoretically drive institutional capital allocation decisions.

Direct engagement - voting proxies, shareholder resolutions, and direct dialogue - is arguably more impactful than secondary market stock selection. Large ESG fund managers like BlackRock and State Street use their ownership stakes to push for climate disclosure and governance reforms.

How to Add ESG to Your Portfolio

If you want ESG exposure, some widely-used options:

Broad ESG index funds:

• ESGU (iShares MSCI USA ESG Select ETF) - 0.10% ER
• ESGV (Vanguard ESG US Stock ETF) - 0.09% ER
• SUSA (iShares MSCI USA ESG Leaders ETF) - 0.10% ER

ESG exclusion approach:

• NACP (Impact Shares NAACP Minority Empowerment ETF)
• ICLN (iShares Global Clean Energy ETF) - thematic, concentrated

A common approach: use a broad ESG fund as a partial replacement for your total market or S&P 500 allocation, rather than converting your entire portfolio.

Want to understand the ESG and sector characteristics of your current portfolio? Analyze your holdings with Prismfolio to see your sector exposure, top holdings, and how your portfolio breaks down across investment themes.