ESG Investing: Does “Going Green” Actually Work for Passive Investing?
Daily lifestyle choices like cycling are often easier to quantify than the real impact of ESG portfolios. Photo by Jonny Kennaugh on Unsplash.
Reading time: 6 minutes
Quick answer
ESG investing (“Environmental, Social, Governance”) can modestly tilt a passive portfolio toward higher-scoring companies along these factors, but it often doesn’t translate into clear real-world environmental impact. Most ESG frameworks measure risk to the company—not harm or impact by the firm to the planet—and ratings vary widely between providers.
For long-term index investors, especially those pursuing Financial Independence, the key question is practical: are the higher fees, tracking differences, and imperfect screens worth the partial value alignment over decades?
What you’ll get from this article
✔ What ESG investing actually measures
✔ The strongest arguments for and against ESG funds
✔ Why passive ESG may deliver less real-world impact than many expect
✔ What individual investors can realistically influence
✔ Practical ways to think about “green” investing without illusions
✔ Whether your time and energy might have higher climate impact elsewhere
TL;DR — ESG Investing in Passive Funds 🌍📈
🧾 ESG was built for risk management, not “saving the planet” (so impact is often overstated)
📊 ESG ratings disagree widely, so ESG can mean very different things across funds
🏭 Many ESG ETFs still hold major emitters via best-in-class screens (less bad ≠ truly green)
💸 Returns are usually similar over time, but expect tracking difference and watch out for fees
🧠 For FI investors, the key is choosing something you can hold for decades without regret
🗳️ Your biggest real-world leverage may come from voting, policy, and consumption, not ETF switching
ESG Investing and Passive Funds: Can You Really Invest Green?
Many investors today wonder whether their portfolios truly reflect their values. The clearest trend is of retail investors wishing to align their portfolio with environmental or climate concerns.
Some may try to align their daily lives along a lower carbon lifestyle—perhaps by eating less or no meat, using the bike or public transport frequently, switching to renewable energy providers, or buying second-hand when possible. These are tangible, visible choices that make them feel better and have a direct, measurable impact on their carbon footprint.
But with investing, as we’ll see in today’s article, things are more complex and not always very transparent. Unlike lifestyle changes, the real-world impact of ESG investing is harder to trace—and sometimes smaller than expected.
If you follow the low-cost, internationally-diversified index funds approach we frequently advocate in this blog, environmentally-minded investors may run into an uncomfortable question: What does “responsible” investing actually look like for a passive investor? Can you preserve the simplicity, diversification, and cost advantages of index investing while still aligning your portfolio with environmental values?
For those on the path to Financial Independence (FI), this question carries additional weight. Your investment strategy is not just an expression of your values, but the engine that is supposed to fund decades of early retirement. If ESG investing—which stands for investing along an environmental, social, and governance framework—reduces diversification, increases costs, or meaningfully alters long-term returns, then the impact of this choice may compound over time.
On the other hand, if alignment can be achieved with minimal trade-offs, then many investors may understandably want to pursue it.
In practice, most ESG funds simply apply screens and/or tilts. The former excludes or reduces exposure to certain companies or sectors while the latter overweights higher-scoring firms based on a chosen ESG methodology.
This article is for readers trying to think through this tension more clearly—myself included. Having worked for more than a decade in climate-related fields, I’ve personally gone back and forth on this question in the past.
Whether you’re simply researching ESG investing or trying to figure out how well your portfolio fits your environmental values and long-term Financial Independence goals, this guide aims to bring clarity. The goal isn’t to dismiss ESG, but to understand what it can realistically achieve—and where expectations may run ahead of the evidence.
Renewable energy investments often feature prominently in ESG narratives—but portfolio impact is usually more complex. Photo by Pixabay on Pexels.
The Best Case for ESG (Why It Exists in the First Place)
The rapid growth of ESG assets—estimated at about $50 trillion globally in recent years—reflects genuine investor concern about sustainability issues. In theory, if enough capital prefers higher ESG firms, then the cost of capital for lower-rated companies could rise, creating incentives for improved behavior. This argument is one of the central pillars of ESG, and is valid depending on ESG’s effectiveness, i.e., whether ESG funds actually exclude or penalize harmful firms in a meaningful way. We’ll come back to this point in later sections.
But it’s important to understand first that ESG was never primarily designed for “saving the planet” directly, but for improving investors’ long-term risk assessment of companies. Environmental regulation, carbon pricing, labor controversies, and governance failures can all create material financial risks for companies. ESG analysis is an attempt to systematically incorporate those environmental, social, and governance risks into the investment decision. Ultimately, investors want to be able to gauge how relevant those risks are and screen companies out that are perceived as too risky to hold.
The argument is that this leads to better-informed capital allocations and more resilient portfolios over long horizons. Crucially, most ESG frameworks focus on financial materiality—how environmental and social issues affect the company’s risk and profitability—rather than double materiality, which would also measure the company’s actual impact on the environment and society. This distinction is central to many of the misunderstandings around ESG. To illustrate, if environmental regulations were weak, then the environmental risk to the company would be scored as low, irrespective of whether that company is a large polluter or not.
In this sense, ESG should be understood less as some form of ethical screening and more as an extension of traditional risk management. Many retail investors are surprised when they find out about this important distinction. It helps to partially explain why certain companies that are not perceived as sustainable by the public still make it into many ESG funds.
However, there is little doubt that ESG has changed boardroom conversations. Climate risk disclosure, supply-chain transparency, and governance oversight receive far more attention today than they did 20 years ago. Large institutional investors routinely engage companies on emissions targets and different reporting standards across the ESG acronym. In that sense, ESG’s indirect cultural and informational impact may have been more meaningful than the simple “green vs not green” framing that is often used by marketing teams of ESG funds.
Once you look under the hood, though, the ESG story gets more complicated.
Large-scale clean energy projects highlight where capital markets can influence the real economy. Photo by Jesse De Meulenaere on Unsplash.
Where ESG Often Misleads Investors
As discussed above, most ESG scores focus primarily on financial materiality (risk to the company), not the company’s real-world environmental impact. This is arguably one of the most important misunderstandings related to ESG. Many ESG ratings focus primarily on how environmental or social issues affect a firm’s financial performance, rather than how the firm affects the environment or society.
A company can score well if it manages its risks effectively—even if the absolute environmental footprint remains large. For environmentally motivated investors, this distinction is easy to miss and often leads to overly-optimistic expectations of what their ESG product is actually accomplishing. Put simply, sometimes we’re expecting it to produce a result it was never designed to fulfill.
Another major complication is that ESG ratings are surprisingly inconsistent across providers. A widely cited academic study by Berg et al. (2019) found the correlation between major ESG rating agencies averaged only 0.54, far below the roughly 0.99 correlation typical for traditional credit ratings. In practice, this means the same company can be rated an ESG leader by one provider and a laggard by another, depending heavily on methodology choices that are often opaque to retail investors.
For passive investors buying ESG tilted ETFs, this means the label can depend heavily on methodological choices that are not obvious at the surface. Environmentally-conscious ESG investors would need to understand really well how the screening was made and whether they ultimately align with that screening procedure or whether they feel it insufficiently meets environmental or climate change impact criteria.
Some ESG funds follow explicitly a “best-in-class” approach that can still include heavy emitters. For instance, they may decide not to exclude entire sectors such as oil & gas or mining, and instead overweight the relatively stronger performers within each industry. Supporters of this approach argue this creates incentives for improvement in sectors where emissions are highest, while critics argue that it dilutes the environmental signal many investors expect. Either way, it’s complicated.
This helps explain why some controversial firms still appear in ESG portfolios—either the ESG risk assigned to them is not very high, or they are simply among the better-performing firms in their sector. Either way, for many retail investors wishing to not place their money on certain energy firms, this answer won’t feel very satisfying.
A related concern increasingly discussed by regulators is the risk of greenwashing—the possibility that some ESG products overstate their environmental rigor relative to their actual holdings. As ESG demand has surged, fund providers have strong commercial incentives to capture flows, which has led to closer scrutiny of how sustainability claims are defined and marketed. For investors, this makes it even more important to look beyond the ESG label and understand the underlying methodology.
Vegan burrito. Dietary choices often have a more direct climate effect than small portfolio tilts. Photo by Gaby Aziz on Unsplash.
Passive Index Funds and ESG: The Structural Dilemma
“Regular” market-cap index funds inevitably include controversial sectors. If you invest in a broad global index, you are effectively buying the entire market—energy producers, miners, airlines, and heavy industry. That broad exposure is precisely what delivers maximum diversification at low cost.
ESG index variants attempt to tilt away from worst performers, but unless screenings are extremely strict, meaningful exposure to these industries usually remains. For passive investors wishing to balance simplicity with strong value alignment, this creates a tension that is structural rather than easily solved by product selection.
Unfortunately, even if you got the right ESG, divestment by small investors may have limited direct impact. Financial research suggests that secondary-market trading—the activity most retail ETF investors engage in—typically has only an indirect effect on companies’ cost of capital, especially in deep and liquid markets.
Because public equity markets are highly liquid, most secondary trades simply transfer ownership rather than directly changing corporate financing conditions, which is why many researchers argue that broad, coordinated capital shifts—not isolated retail trades—are required to materially affect firms’ cost of capital. ESG can still “make a difference” indirectly through norms, disclosure, and engagement—the cultural aspect we mentioned previously—but that’s a slower channel than most people assume and than many marketing narratives imply.
Most ESG ETFs are rules-based and marketed as passive products, but the rules themselves embed active judgement through exclusions, tilts, and scoring frameworks. In practice, ESG funds look passive on the surface, but the built-in screens make active choices about which companies stay in the portfolio. This explains why ESG portfolios introduce some tracking error, slightly higher fees, or mild concentration relative to plain-vanilla index funds.
Even if you accept the imperfections, there’s still the practical Financial Independence question: what happens to returns, fees, and diversification?
Transportation choices often have a more direct climate effect than small portfolio tilts. Photo by Jacques Bopp on Unsplash.
Performance Reality: Does ESG Help or Hurt Returns?
The short answer: historically, ESG has tended to perform similarly to the broad market—but with meaningful variation across time and implementation.
Long-term performance differences between ESG and conventional portfolios are usually modest—but not guaranteed. A persistent myth is that ESG either clearly outperforms or clearly underperforms. The empirical picture is more nuanced. Large meta-analyses reinforce this mixed but generally neutral finding.
A widely cited review of more than 2,000 empirical studies found that roughly 90% reported a “non-negative relationship” between ESG factors and corporate financial performance, with the majority showing neutral effects. In other words, ESG is unlikely to systematically harm returns—but neither does the evidence support reliable outperformance.
In practice, outcomes still vary meaningfully across time periods, sectors, and implementation choices, which helps explain why the ESG performance debate often appears more polarized than the underlying evidence suggests.
But there is no free lunch in investing: adding constraints usually comes with trade-offs. When you exclude sectors or tilt toward certain companies, you are inevitably changing the portfolio’s diversification. Evidence-based investing research often points out that any systematic constraint—ethical or otherwise—can lead to periods of underperformance compared with the broad market. This doesn’t mean ESG will always lag, but it does mean investors should be prepared for some tracking difference and recognize that values-based investing can come with opportunity costs in certain market environments.
Often, fees and implementation may matter more than the ESG label itself. In practice, one of the most reliable performance drags of ESG portfolios has historically been higher expense ratios compared to plain index funds, although this gap has narrowed in recent years. But as we saw in a previous post, even small ETF fee differences can compound significantly over long periods of time. Over multi-decade horizons typical for Financial Independence investors, even small differences in fees or tracking can meaningfully shift your FI timeline.
For passive investors, the biggest risk is often not the ESG screening per se, but paying materially higher costs for relatively modest portfolio changes. Careful fund selection therefore matters far more than simply choosing any product carrying an ESG badge.
ESG impact can be complex and indirect, while many lifestyle choices remain more visible and within personal control. Photo by Galen Crout on Unsplash.
What Individual Investors Can (Realistically) Influence
Consumer choices often have a more immediate and measurable climate impact than small reallocations within a diversified public-equity portfolio. For most individuals, everyday consumption decisions—energy use, diet, transportation, housing efficiency—tend to produce more immediate real-world effects than marginal reallocations within a diversified ETF portfolio. Policy signals, regulation, and voting behavior also drive systemic change more directly than secondary-market trading from passive investors.
Instead, large institutional capital is the primary engine of market pressure. Where capital markets can meaningfully influence corporate behavior is at scale: pension funds, sovereign wealth funds, and large asset managers engaging directly with management teams. Actions like shareholder voting, direct company engagement, and large coordinated investment moves usually have far more influence than the scattered trades of small retail investors. This is why many ESG discussions now focus more on engagement and voting power, rather than simply excluding certain companies from a portfolio.
Stock picking for impact is another possibility—but risky for most investors. In theory, an investor who carefully researches and selectively funds genuinely high-impact companies could align capital more closely with environmental goals. In practice, though, concentrated stock picks substantially increases risk and the probability of underperformance relative to diversified index strategies. For households, you may gain marginal control over alignment but materially increase the risk of undermining long-term financial outcomes.
This is one reason many evidence-based investors still default to broad diversification while expressing environmental preferences through other channels.
For investors pursuing Financial Independence, the practical question is rarely whether ESG is “good” or “bad,” but how much complexity, cost, and tracking difference you’re willing to accept—and how those choices may compound over your path to early retirement.
Because small structural portfolio choices can compound over decades, it’s worth understanding how they affect your Financial Independence timeline.
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Disclaimer: I’m not a financial adviser, and this is not financial advice. The posts on this website are for informational purposes only; please consult a qualified adviser for personalized advice.
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About the author:
Written by David, a former academic scientist with a PhD and over a decade of experience in data analysis, modeling, and market-based financial systems, including work related to carbon markets. I apply a research-driven, evidence-based approach to personal finance and FIRE, focusing on long-term investing, retirement planning, and financial decision-making under uncertainty.
This site documents my own journey toward financial independence, with related topics like work, health, and philosophy explored through a financial independence lens, as they influence saving, investing, and retirement planning decisions.
Frequently Asked Questions (FAQs)
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Not always. Many ESG funds aim to reduce exposure to the worst companies by a score, but still hold heavy emitters under “best-in-class” methods. ESG can mean “relatively better within an industry,” not “aligned with a 1.5°C pathway.” The sustainable label depends on methodology and holdings, not the acronym.
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It can, but the pathway is indirect. Most ETF buying and selling happens in secondary markets, which mainly shifts ownership rather than funding projects. ESG’s stronger impact channels are usually disclosure pressure, corporate engagement, and large institutional voting blocs. That’s real—but slower than most people expect.
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Most ESG ETFs track an index that applies rules: exclusions (e.g., tobacco), tilts (overweight higher scores), or carbon-intensity targets. The fund is “passive” in implementation, but the rules are a choice, which is why ESG products vary so much. Always check the index methodology and top holdings.
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The big ones are messy definitions, inconsistent ratings, and potential higher fees. ESG portfolios can also drift from the market (tracking difference) and become more concentrated. None of this makes ESG “bad,” but it means you should choose it with clear expectations.
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Because it’s often marketed as “doing good,” while many ESG scores mainly measure financial risk to the company. Add inconsistent ratings and occasional greenwashing, and trust erodes. Critics also argue ESG can distract from the harder work of regulation, pricing externalities, and real-world emissions cuts.
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Sometimes, but not reliably. Over long horizons, many studies find performance differences are often modest, with results depending on fees, sector tilts, and time period. The cleaner expectation is: don’t buy ESG for outperformance—buy it for alignment you’re willing to stick with.
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They’re informative, but not “objective truth.” Different providers score different things and weight them differently, so correlations across ratings are much lower than most investors assume. Treat ESG ratings like a lens, not a measurement instrument like CO₂ emissions.
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Only if you can commit to it for decades and the tradeoffs are acceptable. FI investing works best when it’s simple, low-cost, and durable through market cycles. If ESG raises fees, taxes, or complexity materially, it may hurt the FI engine more than it helps values alignment.
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It can be meaningful personally and culturally, but the direct financial pressure from small retail divestment is usually limited in liquid public markets. The bigger levers tend to be institutional engagement, voting, and policy. Divestment can still matter—just don’t overestimate the mechanism.
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Keep a strong low-cost core, then add a small, intentional tilt you understand (e.g., a low-fee climate-tilted fund with clear methodology). Pair that with higher-impact actions: consumption choices, political engagement, and support for climate solutions. Aim for clarity and consistency, not purity.
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