How to Understand ESG: The Essential Guide for Modern Investors

The Boom of Sustainable Investments

The global sustainable investment market has experienced spectacular growth in recent years. In 2020, according to the Global Sustainable Investment Alliance (GSIA), assets under management in sustainable funds reached $30.7 trillion, representing a 38% increase over 2019. This phenomenon reflects a fundamental shift in investor mindset, who now consider non-financial factors when making investment decisions.

The trend is especially strong among younger generations. Millennials and Generation Z are leading this responsible investment revolution, seeking to align their portfolios with their personal values. However, the year 2022 demonstrated that the path of sustainable investments presents significant challenges, with sharp declines in ESG funds due to their high technological exposure and the global energy crisis.

What Does ESG Really Mean in Investment Strategies

ESG meaning is broken down into three fundamental pillars that transform how we evaluate companies:

Environmental (E): Measures the company’s impact on the environment. Includes greenhouse gas emissions, energy consumption, resource efficiency, and waste management. A company with strong environmental performance demonstrates the capacity to adapt to future climate regulations.

Social (S): Assesses the company’s social impact. Considers fair labor policies, respect for human rights throughout the supply chain, diversity in staff, and community contribution. Companies with solid social practices tend to retain talent better and maintain resilient reputations.

Governance (G): Examines leadership structures, corporate transparency, and accountability. Good governance reflects balanced board composition, responsible executive compensation, and anti-corruption policies.

Why ESG Criteria Generate Superior Returns

Scientific evidence supports what many investors already observe: companies committed to ESG standards offer better risk-return profiles over the long term. An analysis of European companies with high ESG performance showed an average return on equity (ROE) exceeding the market by 1.59%.

These companies are better positioned to:

• Anticipate and adapt to new environmental and social regulations
• Mitigate operational and reputational risks
• Capitalize on emerging opportunities in the green economy
• Maintain stability during economic recessions

In 2022, the U.S. Securities and Exchange Commission proposed new climate disclosure rules, while Europe implemented the Sustainable Finance Disclosure Regulation. These measures will regulate the sector and favor companies already aligned with ESG criteria.

ESG versus Other Sustainable Investment Strategies

Although terms like SRI (Socially Responsible Investing), Green Investment, and Impact Investment share philosophy with ESG, they present key differences:

SRI vs ESG: Both use environmental, social, and governance criteria, but SRI is more restrictive. It excludes sectors considered harmful (tobacco, weapons, fossil fuels, gambling), whereas ESG evaluates performance without necessarily excluding.

Green Investment: Focuses exclusively on the environmental component. Invests in renewable energy, sustainable agriculture, and clean technology, but ignores social and governance factors.

Impact Investment: Prioritizes the social factor, aiming to solve issues like poverty, education, and access to housing, often sacrificing profitability for impact.

How to Measure a Company’s ESG Performance

Investors have multiple tools to evaluate ESG commitment:

Corporate Reports: Companies publish sustainability and corporate governance reports, mandatory in many Western countries. However, these reports lack uniform external auditing, leading to variability in methodology.

Specialized ESG Ratings: Agencies like MSCI, Sustainalytics, and Fitch Ratings assign scores based on standardized criteria and public data, facilitating comparisons between companies.

Fund Composition: Analyzing which companies are included in different ESG funds provides insight into market trends and professional managers’ preferences.

Greenwashing Risk: Companies may make false or exaggerated claims about environmental benefits. This deceptive practice requires in-depth analysis beyond official statements.

Leading ESG Funds and Their Characteristics

The top 10 ESG funds accumulated combined assets exceeding $150 billion by the end of 2020. According to MSCI ESG Research, the leading ones by asset volume include:

• Parnassus Core Equity Fund (22.94 billion, +155% since its founding in 1993)
• iShares ESG Aware MSCI USA ETF (13.03 billion, +82% since 2016)
• Vanguard FTSE Social Index Fund (10.87 billion, +45% since 2019)
• Stewart Investors Asia Pacific Leaders (9.87 billion, +34% since 2018)
• Northern Trust World Custom ESG Equity Index (8.69 billion, +88% since 2015)

Technological giants dominate the composition of these funds. Companies like Microsoft, Google, Apple, and Nvidia appear frequently, with Alphabet in 12 main funds with an average weighting of 1.9%. Paradoxically, although the energy sector has a low allocation, 11 ESG funds hold shares of fossil fuel energy companies.

Historical Returns: The Reality of 2022

Over long-term horizons, ESG funds have generated positive and consistent returns. However, 2022 was disastrous for sustainable investments. The accumulated losses resulted from:

• High concentration exposure in technology stocks
• Virtually no participation in fossil fuels (the only sector with 55% returns in 2022)
• Downward pressure from the overall market due to inflation, high interest rates, and geopolitical crisis

Comparisons between ESG funds and conventional funds show significant divergences in short-term profitability, although in the long run, ESG funds regain an advantage in terms of volatility and risk management.

Outlook 2023: Uncertainty but Projected Growth

The economic outlook for 2023 presents a contradictory scenario. Morningstar data shows that sustainable funds attracted $147 billion during the first three quarters of 2022, a 72% decline compared to $528 billion in the same period of 2021. This retreat reflects capital withdrawals caused by poor returns and anti-ESG movements in certain markets.

However, analysts project that the ESG market will grow by 150% by 2025, according to Dow Jones reports. New climate regulations, ongoing environmental concerns, and demand from younger generations will support this growth in the medium term.

Opportunities and Risks of Investing in ESG

Opportunities: Companies with strong ESG practices exhibit lower volatility, better resilience during recessions, and competitive advantages against emerging regulations. Investing in these assets allows contributing to positive environmental and social change simultaneously. Growing institutional demand increases appreciation potential.

Main Risks: The universe of ESG options is smaller than the conventional market, limiting diversification. The lack of standardization in ESG criteria creates confusion when comparing investments. The risk of greenwashing exposes investors to companies that falsify sustainability commitments. Sector concentration (sobreexposure to technology) amplifies volatility.

Conclusion: ESG is Not All or Nothing

ESG investments represent a valuable evolution in investment philosophy, considering environmental and social impact alongside financial returns. Leading companies like Microsoft, Google, Apple, and Nvidia demonstrate that ESG excellence and profitability are not mutually exclusive.

However, the decision to invest in ESG funds depends on time horizons, risk tolerance, and personal values. Investors with short-term objectives may miss opportunities by limiting themselves solely to ESG. Volatility periods like 2022 show that smart diversification, including traditionally excluded sectors, can improve overall returns.

The final recommendation is simple: thoroughly analyze specific companies and funds, combine ESG with other strategies according to your profile, and consult professional advice before making significant financial decisions. No investment is risk-free, regardless of its ESG rating.