ESG stands for environmental, social and governance.

Environmental factors include pollution, carbon emissions and the use of natural resources. Social factors consider how a company treats its employees, customers and communities. Governance looks at how the business is run, including executive pay, board oversight and shareholder rights.

ESG funds use these measures to select investments. Some favour companies with stronger ESG ratings, while others exclude sectors such as tobacco, defence, fossil fuels, gambling, alcohol and mining.

The appeal is obvious. Investors can try to grow their money without supporting industries they consider harmful.

The difficulty is deciding what “ethical” actually means, which can differ from person to person.

Before Russia’s full-scale invasion of Ukraine in 2022, many ESG funds avoided defence companies, while controversial weapons were especially likely to be excluded. Since then, attitudes have shifted as investors have placed greater weight on national security and the role of defence in protecting democratic societies.

The companies did not suddenly become more ethical. The political environment changed around them.

Mining can damage landscapes and create pollution, yet renewable energy depends on metals such as copper, lithium and nickel. Electric vehicles, batteries, wind turbines and power grids cannot be built without them.

Oil and gas companies contribute to emissions, but the global economy still depends on fossil fuels for transport, heating, electricity and manufacturing. Airlines produce emissions, but they also support trade, tourism and international travel.

The real economy cannot always be divided neatly into good and bad businesses.

Removing entire industries changes the risk and return profile of a portfolio.

MoneyWeek recently noted that the FTSE4Good UK index has lagged broader UK indices over five and ten years. Over the past decade, it returned around 57%, compared with 67.5% for the FTSE All-Share and 70% for the FTSE 100.

That does not mean every ESG fund will underperform. Some global ESG funds have performed well because they hold more technology companies.

However, replacing energy, defence and mining with larger technology allocations can create another problem: concentration. The portfolio may look more responsible, but it may also depend more heavily on a small number of highly valued companies.

ESG exclusions will occasionally remove poor investments. At other times, they will exclude some of the market’s strongest performers.

An ethical label does not guarantee better returns.

Most shares are traded between investors. When one investor refuses to own an oil or tobacco company, another investor usually buys the shares instead. The company may see little direct financial impact.

The investor, however, is left with fewer choices.

This matters for pensions and charities, where lower returns could mean less money for retirees or good causes. An exclusion may still be justified by a clear moral conviction, but the trade-off should be understood.

There is little benefit in accepting weaker returns if the decision produces no measurable change in corporate behaviour.

I do not currently use ESG funds.

My priority is broad diversification, low costs and the strongest long-term return available for the level of risk I am willing to take. I do not want whole sectors removed from my portfolio because an index provider has decided they are unacceptable.

That does not mean I oppose the aims behind ESG. Far from it. If an ESG fund could offer the same diversification, cost and expected return as a conventional global tracker, I would be very keen to support it.

For now, I believe the restrictions can create unnecessary compromises without necessarily creating meaningful change.

Investors should not ignore their values. Anyone who strongly objects to tobacco, gambling, weapons or fossil fuels should be free to exclude them.

But ESG ratings are subjective, providers often disagree and the rules can change with political and social attitudes.

ESG investing makes sense when it genuinely reflects an investor’s convictions and they understand the financial consequences.

It makes less sense when higher costs, weaker diversification or lower returns are accepted simply because a fund carries a reassuring label.

Reference: This article was informed by Max King, “Does ESG investing really make sense?”, published in MoneyWeek, 17 July 2026.

The Compounder
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