ESG, SRI, Impact Investing: What Are They, How to Get Started, and How Funds Have Performed

ESG, SRI, and impact investing may seem like last decade's buzzwords, but they now have enough capital and data behind them for investors to pay attention to. 

ESG stands for environmental, social, and (corporate) governance. ESG investors look for companies that lead in those areas in addition to strong financial returns. 

Broadly speaking, ESG investors, socially responsible investors (SRI), and impact investors invest in companies that are both financial winners and leaders in protecting the environment, creating a more just society, and are role models of corporate governance – though their investment objectives differ slightly from each other.

2021 was a landmark year for ESG mutual funds and exchange-traded funds (ETFs). According to Morningstar, $70 billion flowed into ESG funds, up 35% from 2020, which was another record-setting year. In total, sustainable mutual funds and ESG ETFs held $2.7 trillion in 2021, per Morningstar. 

In 2012, there were 104 ESG funds. By the end of 2021, there were 534 ESG funds.

There is also growing data that ESG funds outperformed market benchmarks during 2020 and 2021. Proponents of ESG investing claim that companies that proactively address environmental risks, bolster treatment of employees and local communities, and practice good corporate governance run businesses that are more resilient to financial risks posed by climate change and other issues, for example. 

In response to investor interest in how businesses impact the environment, social justice, and other issues that may not show up on the balance sheet, analysts have come up with ESG metrics to calculate ESG score for firms and funds. 

ESG, SRI, and impact investing have captured the attention of investors, governments, and companies. That attention is likely to only grow as issues like climate change, social justice, and corporate governance stay in the spotlight. 

Key findings

• There were 534 ESG funds at the end of 2021, up from 392 the year before, according to Morningstar. 
• 121 ESG funds were established in 2021, compared to 73 new ESG funds established in 2020 and 31 ESG funds established in 2019.
• Twenty-two percent of institutional investors use ESG considerations in at least 75% of their portfolios, per BNP Paribas. In 2019, zero respondents thought they would do so in the next two years. Forty-seven percent of institutional investors predict that ESG will be central or necessary to their work in two years.
• Seventy-two percent of Americans are interested in ESG investing, according to a Morningstar survey. But 32% of Gen Z and millennial investors said they don't know what an ESG stock is.
• Only 28% of investors are familiar with ESG, 24% can correctly define ESG, and 21% know what ESG stands for, per a survey from FINRA and NORC at the University of Chicago.
• Thirty-two percent of retail investors surveyed by GlobeScan said they are already increasing their ESG investments and 44% said they plan to invest more in ESG stocks in the future. 
• Compared to funds of a similar size and category, 56% of ESG funds outperformed their peers in 2021, according to Morningstar. Over half of ESG funds outperformed their peers over 3-year and 5-year stretches, as well.
• Two-thirds of ESG funds beat the market in 2021, and ESG funds have outperformed over longer terms as well.

What is ESG investing?

ESG stands for environmental, social, and (corporate) governance – three criteria that investors can consider if they want to prioritize the environment and society alongside financial returns. 

These are broad categories that touch on essentially every aspect of a company's operations. We'll break down each of the three ESG factors below.

The best ESG stocks feature strong ESG ratings and address all three of these criteria while delivering impressive returns for investors.

The environmental component of ESG

The environmental element of ESG applies to how a company impacts the Earth. 

This includes actions to reduce its harmful environmental footprint, limit greenhouse gas emissions, conserve natural resources, adopt renewable resources, and provide incentives for employees to reduce their own greenhouse gas footprints by carpooling, biking to work, and adopting other sustainability practices. 

The social component of ESG

The social element of ESG applies to how a company affects its employees, customers, other businesses it works with, and the communities it operates in. 

This includes employee compensation, treatment, turnover, training, and development. It also includes company policy related to employee safety, sexual harrassment, discrimination, diversity and inclusion, and so on. 

The social aspect of ESG also encompasses how a company interacts with other businesses and its local community. This includes ethical sourcing and supply chains, consumer protection, and how it chooses to weigh in on local, state, and federal policy issues. 

The governance component of ESG

The corporate governance component of ESG captures a company's board, leadership, and business ethics. 

This includes how executive compensation is structured, the diversity of board members, board independence, how board votes are decided, how board members are chosen, and for how long they can serve. 

The corporate governance component of ESG also covers whether a company issues dual- or multiple-class stock, their track record of shareholder transparency, and relationship with government agencies like the Securities and Exchange Commission (SEC). 

What is an ESG score, rating, or metric?

An ESG score or ESG rating measures a company's resilience to ESG financial risks. 

There is no single universally accepted ESG score or rating. Nor are there standard ESG criteria used to reach those scores, although there are a number of reputable sources. Those include the following:

• Morningstar 
• MSCI
• Sustainalytics

These and other companies that provide ESG scores may rely on data provided by companies that self-report on their ESG efforts. 

Companies' own reports on their ESG activities may be useful for independent research, as well. The most reputable reporting will follow standards set by the Global Reporting Initiative (GRI) or the United Nations Principles for Responsible Investment (PRI).

MSCI, which provides ESG ratings for over 2,900 companies, bases its scores on 35 industry-specific ESG issues in addition to 350 other universal ESG metrics. 

Companies are given a score out of 10 for each metric, with a low score indicating insufficient action to address a risk and a high score indicating strong action to address a risk. 

MSCI weights risks based on their impact and timeline. Risks that are high-impact and near-time are given a larger weight. 

Once scored and weighted, MSCI provides a final company score from 0 to 10, which corresponds to a ranking scale from CCC at the low end to AAA at the high end. 

Importantly, much of the data behind ESG metrics and scores are reported voluntarily by companies and are not subject to regulatory requirements. As a result, data gaps and inconsistent data quality are common, and ESG ratings may be less precise as a result.

Governments, however, are starting to crack down on funds that greenwash and advertise themselves as ESG funds. Moreover, there's growing momentum among regulators to require ESG-relevant disclosures from companies.

Starting in the middle of 2021, the SEC began writing letters to managers of ESG funds asking for data and metrics used to market those funds as ESG funds. In March, the SEC approved new rules that require public companies to inform shareholders and government agencies how their operations affect the climate. 

The European Union adopted the Sustainable Finance Disclosure Regulation, which sets new environmental disclosure and transparency requirements for funds. 

What is SRI?

Socially responsible investing focuses on companies that make a positive social difference without compromising their performance. 

SRI is similar to ESG, although has a higher bar for the social impact a company creates. 

Investors that adopt a SRI strategy generally avoid certain industries that run counter to their values and have or could have harmful effects on society. Industries that are commonly excluded from SRI strategies include gun manufacturing, tobacco production, gambling, predatory lending, adult entertainment, and nuclear power. 

What is impact investing?

Through impact investing, investors aim to generate positive social or environmental outcomes from their investments. 

While similar to ESG and SRI, impact investing is more focused on utilizing capital to create a measurable positive impact, even if that capital could have generated a larger financial return for the investor elsewhere.

Impact investing can be done through philanthropic organizations with specific missions, like tamping out deadly disease or providing clean drinking water to those in need. 

Are investors interested in ESG funds?

ESG funds are one of the most popular and accessible ways to get started with ESG investing. These include exchange-traded funds (ETFs) composed of ESG-friendly companies. 

ESG funds and ETFs have attracted significant attention and capital in recent years. 

As of the end of 2021, there were 534 ESG funds, up from 392 the year before, according to Morningstar. 

The number of new ESG funds established every year has steadily increased as well: 31 funds were established in 2019, 73 were established in 2020, and 121 were established in 2021. 

In another sign that institutional investors are leaning into ESG, a BNP Paribas survey found that 22% of institutional investors use ESG considerations in at least 75% of their portfolios. In 2019, zero respondents thought they would do so in the next two years. 

That same survey found that 21% of institutional investors view ESG as central or necessary, up from 10% in 2019. Forty-seven percent predict that ESG will be central or necessary in two years. And just 1% think that ESG will only play a minor role in two years. 

More evidence that ESG is entering the mainstream is the fact that 45% of institutional investors surveyed by BNP Paribas said ESG capabilities are embedded across their organization, up from 23% in 2019. 

What do retail investors think about ESG investing?

ESG mutual funds and ETFs have seen growth and interest among institutional investors, but retail investors have been slower to consider them.

In response to a Motley Fool survey, just a quarter of Gen Z and millennial investors reported owning ESG stocks, while 32% said they don't know what an ESG stock is.

More evidence of ESG investing facing a knowledge and awareness gap among individual investors comes from a recent survey from FINRA and NORC at the University of Chicago. That survey found that only 28% of investors said they are familiar with ESG, 24% correctly defined ESG, and 21% know what ESG stands for. 

Among investors that don't hold ESG investments, 46% said it hadn't occurred to them to pick ESG investments, 31% said they don't know how to pick ESG investments, and 28% said they don't know how to tell if an investment is ESG-focused, per FINRA and NORC at the University of Chicago. 

Similar to the Motley Fool survey, just 9% of respondents to the FINRA and NORC at the University of Chicago survey reported holding ESG investments. Thirty-six percent said they were unsure if their taxable brokerage account held ESG investments. 

Still, other data suggests there's more of an appetite among retail investors for sustainable investing, particularly younger investors. 

Morningstar found that 72% of Americans are interested in ESG investing, with millennials showing slightly more interest than older generations while FINRA and NORC at the University of Chicago investors under 30 years of age were more likely to be familiar with ESG than older respondents. 

The survey from FINRA and NORC at the University of Chicago found that 57% of Americans believe investing can be a vehicle for positive change, and 77% of Americans believe that companies that are in ESG funds align with their values. 

A survey of investors from 31 different countries from GlobeScan came to the same conclusions. 

Almost a third of respondents said they don't have sufficient information to determine what investments are socially and environmentally responsible despite 82% saying they want to invest in socially and environmentally responsible companies. 

Despite information being hard to come by and sift through, 32% of investors surveyed by GlobeScan said they are already increasing their ESG investments and 44% said they plan to invest more in ESG stocks in the future. 

GlobeScan also found that baby boomers are less likely to know about ESG investing, are less interested in ESG, and less likely to believe that ESG investing can yield strong financial returns. 

Yet most retail investors don't think they'll sacrifice financial returns by using ESG to guide their investments. 

Per FINRA and NORC at the University of Chicago, only 27% of investors think that companies which prioritize their impact on the environment and society will yield lower returns than the market. Forty-one percent think those companies will post returns in line with the market while 14% believe ESG-focused companies will beat the market. 

GlobeScan found that 70% of retail investors believe the more socially and environmentally responsible a company, the more likely they are to deliver strong financial returns for companies. 

ESG performance: what does the data say?

Compared to funds of a similar size and category, 56% of ESG funds outperformed their peers in 2021, according to Morningstar. Over half of ESG funds outperformed their peers over 3-year and 5-year stretches as well.

Data source: Morningstar (2021). 

Two-thirds of ESG funds beat the market in 2021, and ESG funds have outperformed over the longer-term as well. Over the last 3 years, 56% of ESG funds beat the Russell 1000 compared to 21% of all large blend funds, and over the past 5 years 40% of ESG funds beat the index compared to just 18% of large blend funds. 

Data source: Morningstar (2021). 

Below is a list of the largest ESG funds, along with how they have performed over the last five years. 

Data source: Morningstar, iShares. 

Despite oil and gas having a strong showing in 2021, major ESG ETFs still managed to have strong years. ESG funds managed by MSCI compensated for minimal exposure to oil and gas by being overweight in sectors that posted strong returns, like semiconductors, and underweight in sectors that lagged the market, like airlines and defense. 

What's next for ESG investing?

ESG investing has entered the mainstream. Most websites that provide information on a company's stock now include ESG information. Investors are increasingly conscious about climate change, sustainability, and social justice, and expect companies to adopt net zero policies and weigh in on social justice issues. Government regulators are forging ahead with standard setting and regulation around ESG for fund managers and companies. 

Data is beginning to show that investors who incorporate ESG ratings into their strategies may find their portfolios better suited to adapt to, and even take advantage of, radical changes driven by climate change and social movements. 

Climate's ascendance as a top priority among governments, companies, and investors also raises ESG questions that investors and regulators will need to grapple with. Will companies that are ESG role models be responsible for the environmental footprint of their suppliers? Will regulators from different countries harmonize ESG regulations or will fragmented systems emerge? Will large funds continue to lean into ESG strategies? And how will investors use ESG principles in their own investing?

Data sources:

• BNP Paribas (2022). "The ESG Global Survey 2021."
• GlobeScan (2021). "Retail Investors Show Strong and Growing Interest in ESG."
• FINRA and NORC at the University of Chicago (2022). "Investors say they can change the world, if they only knew how: Six things to know about ESG and retail investors."
• Morningstar (2021). "Global Sustainable Fund Flows: Q4 2021 in Review."
• Morningstar (2022). "Sustainable Funds U.S. Landscape Report."
• Morningstar (2019). "The True Faces of Sustainable Investing Busting Industry Myths Around ESG." 
• MSCI (2021). "2022 ESG Trends to Watch."
• MSCI (2021). "ESG Indexes Through the Slump and Rally of 2020." 
• MSCI (2022). "Despite Oil & Gas's Rebound, ESG Indexes Outperformed."