7 ESG Investment Strategies to Consider | HBS Online (2024)

As environmental and social issues intensify, the spotlight is on businesses to address growing global concerns. It not only matters how a business performs financially but how it operates and what it stands for.

If you manage investment portfolios, you can invest in firms with high environmental, social, and governance (ESG) ratings to positively impact the world while maximizing returns for your firm and clients.

Here’s a primer on ESG criteria’s role in the investment space and seven strategies to consider for purpose-driven decision-making.

What are ESG Investment Criteria?

You can use environmental, social, and governance (ESG) factors to evaluate the extent to which a company—and thus, an investment in that company—impacts each of the three areas.

• Environmentalrefers to a firm’s impact on the environment, including its contributions to climate change, carbon footprint, water use, resource conservation, pollutants, and clean technology use.
• Socialrefers to a company’s relationships with employees, suppliers, customers, and communities, as well as its contributions toward social good—for instance, human rights, diverse hiring practices, workplace safety, labor practices, data security, and employee and community engagement.
• Governancerefers to an organization’s structure, ethics, and management, which include board diversity and independence, executive compensation, transparency and anti-corruption policies, and shareholder rights.

Research conducted by Harvard Business School Professor George Serafeim, explained in the online course Sustainable Investing, states that businesses are most successful in ESG and financial performance measures when efforts are pooled to focus only on factors that directly impact how a company operates—referred to by Serafeim as material ESG factors.

For example, if you own a small technology company with 10 employees, data security would be considered a material ESG issue because your business handles user data. Other factors, like labor practices, would be considered immaterial to your business at its current startup stage and aren’t worth your time, effort, and funds to pursue.

How Investors Use ESG Criteria

“With the growing popularity of incorporating ESG criteria into the decision-making process, sustainable investors are asking for more credible and comparable ESG ratings to help them better understand a company’s ESG performance,” says HBS Professor Shawn Cole, who teaches Sustainable Investing alongside HBS Professor Vikram Gandhi.

According to Cole, only about 30 firms worldwide conduct research to provide comprehensive ESG ratings. Leaders in this space include Morgan Stanley Capital International (MSCI), Sustainalytics, and Thomson Reuters. Although each firm has its own data processing model and classification system, ESG metrics can be extremely useful to investors aiming to make both a positive impact on the world and strong returns on their investments.

As long as you use the same metrics across the board—for example, consistently referencing MSCI’s ratings—you can directly compare companies’ ESG performance and decide which investments to include in your or your clients’ portfolios.

Remember to be wary of impact washing. Similar to greenwashing, impact washing is when fund managers or bond issuers overstate or falsely claim an investment’s positive impact. Doing your own research, in addition to referencing ESG ratings, can help avoid this common pitfall.

Related:5 Skills Every Sustainable Investor Needs

7 ESG Investment Strategies to Consider

When building a portfolio with ESG factors in mind, there are seven key strategies to consider. Because sustainable investing is relatively new, there aren’t yet official standards for how to incorporate these factors into decision-making, so choose which best aligns with your motivations, goals, and existing processes.

1. Negative Screening

Negative screening, also called exclusionary screening, is the process of excluding specific companies or sectors from a fund or portfolio. This is executed by determining the criteria for exclusion upfront based on a specific goal.

For instance, if the goal is to decrease climate change’s impact, you may exclude all fossil fuel companies from your portfolio.

2. Positive Screening

Positive screening, also called best-in-class screening, is the process of selecting a subset of top-performing companies from a defined industry and a set of characteristics to invest in.

This can be thought of as the opposite of negative screening. Instead of setting criteria by which to exclude companies, you pre-determine which performance measures you’ll use to select top performers.

For example, you may invest in the 10 apparel companies with the lowest carbon footprint or the five appliance companies with the most diverse boards of directors.

3. Portfolio Tilt

A portfolio tilt strategy is one in which the investor “tilts” the percentage of ESG investments in a portfolio to be more than non-ESG investments while maintaining sector weights that match a target index.

For instance, if you want to match the Russell 3000 index and employ a tilt strategy, you’d select investments from across the index to maintain the same level of risk as the index as a whole. You’d also want to ensure there are more highly rated companies on ESG metrics than low ones.

You may choose this option as a relatively low-risk investment strategy that still prioritizes ESG goals. Positive and negative screening—while highly effective at targeting ESG goals—don’t offer a wide industry variety and naturally exhibit more risk.

4. ESG Integration

ESG integration is a strategic lens that positions companies with high material ESG ratings as investment opportunities that can increase a portfolio’s return. Rather than defining a specific set of requirements—like with positive and negative screening—this strategy embeds ESG considerations into a firm’s existing investment process. It’s another factor that helps provide returns.

You may need to update procedures to consider ESG factors to implement this strategy.

5. Shareholder Action

Shareholder action, also referred to as engagement, is when investors use their power to encourage the companies they invest in to pursue material ESG opportunities.

According to research from the Harvard Law School Forum on Corporate Governance, investors increasingly view corporate attention to ESG issues as closely linked to business resilience, competitive strength, and financial performance. If you invest in a company, advocating for material ESG initiatives can not only do good but increase your returns.

6. Activist Investing

Activist investing is when an investor buys equity in a company to change how it operates and influence it to pursue ESG initiatives. This strategy is closely related to shareholder action; the two terms are sometimes combined into “shareholder activism.” However, there’s one key differentiator: Shareholder action takes place when an investor already owns a company’s shares, and activist investing involves seeking out an investment to influence a company’s ESG strategy.

You may decide to pursue this if you notice a company overlooking a major material ESG opportunity. By buying equity in it now, you can influence its structure and plans to approach ESG and, hopefully, see large returns when the new strategy pays off.

7. Sustainability-Themed Investing

Finally, sustainability-themed investing is a strategy in which investors identify one issue relating to sustainability and invest in indexes of companies that address it.

For instance, if you’re specifically interested in waste management as it relates to the planet’s health, compile an index of companies with exceptional waste management across an array of sectors and risk levels.

This strategy is similar to positive screening, but instead of selecting the top-performing companies, an index is created. In addition, positive screening can apply to any ESG factor, while sustainability-themed investing is specific to issues relating to the environment.

Investing for Positive Impact

The ESG investment strategy you select depends on your firm’s existing structure, processes, and values, as well as your and your clients’ motivations surrounding ESG factors.

No matter which you employ, you can create portfolios that provide returns, both financially and for the greater good.

Are you interested in learning more about how to make a positive impact through investing? Download our free e-book on how to be a purpose-driven, global business professional. Also, explore Sustainable Investing, one of our online business in society courses.