ESG investing explained: what environmental, social, and governance criteria mean for a portfolio
ESG investing applies environmental, social, and governance criteria to the selection and weighting of portfolio holdings, alongside or instead of purely financial criteria. Environmental factors include carbon emissions, water usage, deforestation, and exposure to physical climate risk. Social factors cover labour practices, supply chain standards, community relations, and employee welfare. Governance factors address board composition, executive compensation, shareholder rights, and anti-corruption practices. ESG criteria can be applied in many different ways—exclusion, integration, best-in-class selection, or active engagement—and the term covers a wide range of investment approaches that differ substantially in their implementation and objectives.
How ESG criteria are applied
Exclusion-based ESG screening removes companies or sectors that fail a minimum standard on ESG criteria. The oldest form of this is ethical exclusion—removing tobacco, alcohol, weapons, or gambling stocks on moral grounds. Modern ESG exclusions often target fossil fuel producers, companies with poor labour practices, or those with significant environmental violations. The impact on the portfolio depends on how broadly the exclusions are drawn: removing the largest 10% of carbon emitters has a different effect on the portfolio's return and risk profile than removing only the top 1%.
Integration approaches use ESG data as an additional input in the security selection or weighting process, rather than as a hard exclusion filter. A portfolio using ESG integration might overweight companies with improving governance scores and underweight those with deteriorating environmental profiles, without excluding any sector entirely. This approach preserves more of the investable universe and avoids the tracking error concentrations that come from broad exclusions.
Best-in-class selection picks the highest-ESG-scoring companies within each sector, allowing broad sector coverage while rewarding leaders on ESG metrics. This preserves sector diversification better than exclusion but requires reliable, consistent ESG scoring—which, as discussed below, is a significant practical challenge.
The evidence on ESG and returns
The evidence on whether ESG investing improves, reduces, or leaves unchanged risk-adjusted returns is genuinely mixed. Friede, Busch, and Bassen (2015) conducted a meta-analysis of over 2,000 studies and found that the majority showed a non-negative relationship between ESG scores and corporate financial performance. However, the literature conflates many different ESG approaches, asset classes, time periods, and measurement methodologies, making it difficult to isolate a clean causal effect.
The more directly investable question—whether ESG-screened equity portfolios have delivered better risk-adjusted returns than unscreened benchmarks—has a less clear answer. During the period from approximately 2017 to 2021, ESG indices outperformed primarily because they underweighted energy and overweighted technology—sector tilts driven by the construction methodology that happened to align with market conditions, rather than by ESG factors per se. When energy outperformed in 2022, many ESG strategies underperformed significantly for the same reason. This suggests that much of the observed outperformance of ESG strategies over certain periods reflects factor and sector tilts rather than a direct ESG premium.
Definitional and data challenges
A significant practical challenge with ESG investing is the low correlation between ESG scores assigned by different data providers. Berg, Koelbel, and Rigobon (2022) documented that the correlation between major ESG rating agencies' scores for the same companies ranges from approximately 0.38 to 0.71—far lower than the near-perfect correlation between credit ratings from different agencies. This means that a company rated highly on ESG by one provider may be rated poorly by another, and the composition of ESG indices and funds varies substantially depending on which data source they use. An investor who believes they are implementing a consistent ESG policy across providers may in fact be holding quite different underlying portfolios.
Role in a systematic portfolio
ESG criteria can be incorporated into a systematic portfolio as constraints or tilts without replacing the underlying return-generating signals. An ESG constraint—exclude the bottom 20% of ESG scores, or limit carbon emissions to below a defined threshold—acts as a portfolio constraint that reduces the feasible set of investments. The cost of the constraint is the tracking error or reduction in Sharpe ratio caused by excluding those assets. The benefit is alignment with the investor's values or risk management objectives. Whether that cost is worthwhile is ultimately an individual decision, not a purely financial one.
ESG in pfolio
pfolio supports construction of multi-asset portfolios from a universe that includes ETFs covering ESG-screened equity and fixed income indices. Portfolio composition and asset class allocation are visible at pfolio Assets and in pfolio Insights.
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