What Is ESG Investing? How ESG Funds Work

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ESG investing is an approach to choosing investments that weighs a company’s environmental, social, and governance (ESG) performance alongside its financial results. An ESG fund is a mutual fund or exchange-traded fund that applies those criteria when it decides which securities to hold, how much of each to hold, or which companies to press for change. ESG does not mean a single standard. Each fund sets its own rules, so two products with “ESG” in the name can own very different portfolios.

What ESG Means

Each letter covers a different set of questions about a company.

• Environmental: climate policies, energy use, direct and indirect greenhouse gas emissions, waste and pollution, handling of toxic materials, conservation of natural resources, animal treatment, and compliance with environmental regulations.
• Social: how the company treats the people it deals with, including employees, suppliers, customers, and local communities. Workplace health and safety, wages, supply chain practices, and community involvement fall here.
• Governance: how the company is led and held accountable. This includes accurate and transparent accounting, board composition and independence, executive pay, audits and internal controls, shareholder rights, conflicts of interest, and whether political contributions are used to win preferential treatment.

For a business, adopting ESG principles means building these policies into corporate strategy: cutting pollution and carbon output, investing in its community, and building a diverse workforce and board. For an investor, ESG is a lens for judging whether a company manages risks that may not yet appear in its earnings.

How ESG Funds Work

A fund manager turns ESG criteria into a portfolio using one or more of these methods:

1. Exclusionary (negative) screening: removing whole industries or companies that fail set thresholds, such as tobacco, weapons, or thermal coal.
2. Best-in-class selection: keeping companies from every sector but favoring those with the highest ESG scores among their peers.
3. ESG integration: feeding ESG data into ordinary financial analysis as one risk factor among many, without automatic exclusions.
4. Thematic investing: concentrating on a theme such as clean energy or water.
5. Engagement and proxy voting: holding shares and using shareholder votes and dialogue with management to push for changes.

The criteria themselves are usually set by analysts who identify the issues most relevant to each sector, since water use matters more to a beverage maker than to a software firm. Trillium Asset Management illustrates how specific the rules can get. It reviews how companies limit harmful pollutants and chemicals, use renewable energy, pay fair wages, run ethical supply chains, keep diverse boards, and report transparently. It also excludes companies that earn 5% or more of their revenue directly from coal or hard rock mining, gambling, tobacco, private prisons, or weapons, along with companies that have problems involving human rights, animal welfare, the environment, governance, or product safety.

Index-based ESG products work the same way, except the rules are written into the index methodology. Like any ETF, an ESG ETF then tracks that rules-based index.

Example of an ESG Exclusion Screen

Hypothetical example, for illustrating mechanics only.

Assume a broad index in which companies that fail a fund’s exclusion rule make up 4% of the index by weight. The ESG version removes them and scales up the remaining 96% proportionally.

• A company weighted at 2.0% in the parent index becomes 2.0 ÷ 0.96 = about 2.08% in the ESG version.
• Assume over one year the excluded group returns 20% and the rest of the index returns 10%.
• Parent index return: (0.04 × 20%) + (0.96 × 10%) = 10.4%.
• ESG version return: 10.0%, before fees.

If the excluded group had instead returned 0%, the parent index would have earned 9.6% and the ESG version would have come out ahead. The screen does not determine whether the fund wins or loses. It determines that the fund will differ from the benchmark whenever the excluded companies behave differently from the rest. Measures such as the Sharpe ratio and alpha help compare an ESG fund with its parent index on a risk-adjusted basis.

How to Tell Which Investments Are ESG

Several firms publish ESG ratings. As of June 30, 2024, MSCI’s rating system covered more than 17,000 companies, assigning scores and letter grades based on how each manages ESG risks and opportunities. Morningstar and Bloomberg also produce ESG scoring criteria and data.

For a fund, the most reliable source is its prospectus and methodology document, which state:

• which screening methods it uses and at what revenue thresholds,
• which ratings provider, if any, it relies on,
• whether it votes proxies or engages with companies, and
• what it charges, since ESG products may carry different fees from their conventional counterparts.

A fund name alone says little. One “ESG” fund may exclude fossil fuels entirely while another holds oil majors with above-average scores among energy companies.

Why Investors Use ESG

Investors use ESG criteria for two broad reasons. Some want their holdings to match their values. Others treat ESG factors as financial risks: a company with weak governance, poor safety records, or heavy emissions exposure may face fines, lawsuits, or regulatory costs later.

Large institutional investors, including public pension funds, apply ESG analysis, and brokerages and fund companies offer ESG ETFs and mutual funds. Robo-advisors such as Betterment and Wealthfront have promoted ESG portfolios to younger investors. Morningstar reported that sustainable funds held $3.2 trillion in assets globally in the fourth quarter of 2024. Major banks, including JPMorgan Chase, Wells Fargo, and Goldman Sachs, publish annual reports on their own ESG approaches.

Limitations of ESG Investing

Possible return tradeoffs. Industries often excluded by ESG funds, such as tobacco and defense, have historically produced above-average returns and have sometimes held up during recessions. Avoiding them can mean giving up those gains, as the example above shows.

Inconsistent ratings. Providers weigh factors differently, so a company can rank highly with one rater and poorly with another. A rating reflects one provider’s methodology, not an objective measure.

Greenwashing. A company can publish polished sustainability reports without changing how it operates, and a fund can market itself as ESG while making only minor changes to a conventional portfolio. Whether ESG investing achieves anything depends on whether its criteria are realistic, measurable, and actionable rather than box-checking exercises.

Concentration. Removing sectors narrows the investable universe and can tilt a portfolio toward certain industries, such as technology, increasing exposure to their swings.

ESG vs. SRI, Impact, and Sustainable Investing

These terms are often used interchangeably, but they describe different things:

• Socially responsible investing (SRI) focuses on one facet of ESG: ethical and social values such as diversity, inclusion, community focus, social justice, and corporate ethics. It often relies on excluding objectionable businesses.
• Impact investing aims for measurable positive outcomes, such as funding affordable housing or renewable energy projects, alongside a financial return. The outcome is the goal, not a side effect.
• Sustainable investing is the broadest umbrella. ESG examines how a company’s management and stakeholders make decisions; sustainability looks at the effect those decisions have on the world.

FAQs

The Bottom Line

Anyone considering an ESG fund should read its prospectus and methodology document before buying, since the name alone says little about what it owns. Check which screens and revenue thresholds it uses, which ratings provider it relies on, whether it votes proxies, and what it charges. Expect returns to differ from a broad benchmark whenever excluded industries perform differently from the rest of the market.