If you want to invest in companies that share your values, consider environmental, social, and governance (ESG) funds. They aim to invest in companies that are overall environmentally friendly, socially responsible, and ethically governed. That sounds great – but before you jump into investing in ESG funds, you'll need to confront some key risks.
Not all ESGs are alike
Some companies may not be living up to their stated ESG principles. One analysis by the climate-change think tank InfluenceMap found that 71% of ESG equity funds invest in companies that fall short ofwhen it comes to aligning with The Paris Agreement, a legally -binding UN treaty which calls on countries to reduce greenhouse gas emissions.
But that's not to say there aren't a few gems in the mix. The InfluenceMap study found that the funds it analyzed have Portfolio Paris Alignment scores ranging from -42% to +90%.
ESG funds may also fail to truly align with your values. Some highly rated ESG funds may invest in fossil fuel companies. Others' component stocks may have strong environmental records, but lack adequate safety policies in place for their workers.
You need to scrutinize ESG funds to ensure that they hold companies that reflect your principles. Here are some sources you can use to evaluate ESG funds and the companies they track:
MSCI ESG Ratings & Climate Search Tool and the Sustainalytics Company ESG Risk Ratings tool: There is no universally recognized ESG rating criteria, but these are two of the most popular ESG rating tools. You can use these to look up companies and examine their ESG track records.
Ethical Consumer: Established in 1989, this organization provides free sustainability reports covering more than 40,000 companies, shedding light on controversial or environmentally hazardous business practices.
The SEC EDGAR website: Here, you can search for the filing type DEF 14A for different companies to access proxy statements. The SEC requires companies to file these documents, which present key points to be discussed in special stockholder meetings. These can give you a glimpse into changes to boards of directors, salaries of directors, and other governance information.
Company websites: Explore press releases and investor relations pages to see whether companies can back their ESG claims with sound evidence.
Fund prospectus: Beyond providing crucial information about a fund's holdings and past performance, you can also use this document to find information about the fund's objectives and its management team.
But even if you can prove that an ESG fund or company truly aligns with your values, you can't forget the fundamentals.
Green funds don't always make green
Sure, it's nice to support a company that is doing all it can to protect our planet and its people. But if you're investing in these companies, you want to make sure they can deliver consistent returns. ESG funds' ability to do that isn't always clear.
A Morningstar (NASDAQ: MORN) report found that as of June 2022, 65% of sustainable U.S. equity funds lay at the bottom of their Morningstar Category rankings for year-to-date performance. But this trend may not directly be influenced by the concept of ESG itself. According to the Morningstar report, many ESG funds have heavy weightings in tech stocks, which have faced some downturns this year. Still, ESG funds may also paint a better long-term picture. The same report noted that in the long run, 53% of U.S. equity ESG funds made their way to the top half of their category.
Overall, you need to carefully engage in your own due diligence when selecting ESG funds. Make sure the companies they invest in truly reflect your values and have the fundamentals to back up reliable performance expectations. You can take a look at the fund's prospectus online to examine itstheir returns over the years, for example.
And if you're not satisfied with these funds, you can always build your own ESG-driven portfolio by picking the ESG stocks of companies you deem reputable in this space.
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Fool contributor Javier Simon holds no financial position in any companies mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.