Interest in ESG investing continues to grow at a rapid pace, and there are no signs to indicate that this investment trend is going to decelerate.

Interest in ESG investing continues to grow at a rapid pace, and there are no signs to indicate that this investment trend is going to decelerate. Since 2012, global investment in ESG centred products have more than doubled to almost $31 trillion, up from $13.3 trillion – a mere eight years.

In Australia, the growth has been even more convincing. Investment in products with a specific ESG investment objective increased by 60% and screened investments – investments which exclude companies based on characteristics such as alcohol or gambling for instance – grew by 45% in 2018.

Further, according to 2020 research published by the Responsible Investment Association Australasia, responsible investing currently accounts for 44% of the $2.25 trillion professionally managed investment universe, up from 17% from five years ago. Further, Australian investors are seen to be some of the most ESG-aware in the world, with 86% of Australians expecting their super or other investments to be responsibly and ethically invested. An even higher percentage (89%) want their investments to be invested with social and or environmental factors in mind.1

Whether or not this investor sentiment is in response to global events or here at home – who could forget the fiery images of the 2020 bushfires - the message is clear: investors who support investments consistent with their values are no longer on the fringes but fast becoming the mainstream. But you might be holding back from investing in a product with a specific ESG investment tilt because you've heard they are more expensive, or that you can't achieve diversification. Well here are a few things you should know about ESG investing that might help you realise why this investment trend continues to grow in popularity.

#1 – Not too niche for a core portfolio

It is still a commonly held perception that ESG products are too niche and should only be used in the satellite portion of your portfolio. However, the increasing popularity of ESG investing has resulted in new and differentiated products being launched. There is now greater choice and availability of broadly diversified ESG products that could be used as the core of any investment portfolio.

And while more choice is a great thing, it also means doing your research before jumping in head first. Because as with everything in life, not all ESG products are created equal. Investors should seek to understand the underlying ESG approach. If a managed fund or ETF utilises exclusions – weapons manufacturers, vice and fossil fuels for instance – investors should look at what portion of the broad market has been excluded, and determine if that is a suitable exposure for the core of their portfolio.

#2 – ESG investing returns are comparable to broad market returns

As noted above, ESG products do not reflect the broad market, which can be a result of the exclusions or screens applied to the investment and thus investors should also be aware that returns could vary from the broad market, whether that be underperformance or outperformance. For instance, ESG screened products typically outperformed the broader market during the first half of 2020, due to the minimal exposure to oil and gas markets which were particularly volatile during the initial stages of the pandemic. However there is no telling if oil and gas markets will bounce back or whether this trend of outperformance will continue for the long run. Based on Vanguard's research, an investor can generally expect similar returns with an ESG product over the long term to that of the broad market.

#3 – ESG can be both active and index

Vanguard is known for our index funds and strategies so it may come as a surprise that we are of the view that active and index strategies can work hand in glove to deliver a broader, well diversified portfolio. Accordingly, ESG investing is not limited to an active investing strategy. You can choose to be an active investor by seeking alpha with an ESG filter applied. Or you could choose to invest in an ESG index fund which provides a broad exposure and diversification, that still reflects your values and beliefs. It is important to note that either option should be viewed in the context of ultimately building a broadly diversified, low cost portfolio, that takes a long-term view.

#4 – Bonds can be sustainable investments too

If ethical considerations are important when building a well-diversified investment portfolio, why would you stop at the equity sleeve of a portfolio? Companies issue both bonds and equity. It would be inconsistent to exclude an equity based on ethical considerations only then to invest in the same company through their debt or bonds. Investing in a bond fund that reflects an investor's values can be as simple as it is on the equity side, particularly as the number of ESG bond funds continue to grow. Similar to ESG equity funds, ESG bond funds may screen out companies that engage in activities that are on an exclusion list and by investing in both you can be assured that your entire portfolio represents your ethical values not just part of your portfolio.

At the end of the day, whether you choose to make ESG the core of your portfolio, or as part of an overall portfolio, you should always consider your decision in the context of your long-term goals, risk appetite and what you're paying in fees. The good news for investors who want their portfolio to reflect their values is, the more popular ESG becomes, the more choice that is available, leading to lower costs, investors feeling good and with the potential for strong performance.

An iteration of this article was first published in Firstlinks on 28 October 2020.

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