Investors question whether ESG allocations are achieving the impact they expect from their capital decisions.
Trillions of dollars have poured into environmental, social and governance funds (ESG) in recent years. For a financial phenomenon this pervasive, however, there is astonishingly little evidence of its tangible benefit.
The implicit promise of ESG investing was inspired: Do well financially – and do good at the same time. Investors bet in record numbers that you can make a market return and cure ills like income inequality and excessive carbon emissions.
False flag?
Think again: ESG strategies are doing little of either, write Bradford Cornell of UCLA and Aswath Damodaran of New York University after reviewing shareholder value created by firms with high and low ESG ratings. “Telling firms that being socially responsible will deliver higher growth, profits and value is false advertising.”
Over the last five years through mid-2022, global ESG funds underperformed the broader market with a 6.3% return compared with an 8.9% return. A $10,000 investment in a worldwide ESG fund in 2017 would now be worth about $13,500, compared to $15,250 for a broad market index.
Did the forgone profit somehow do $1,750 worth of good for humankind? Apparently not. Researchers at Utah, Miami and Hong Kong universities find “no evidence that socially responsible investment funds improve corporate behavior.”
This was predictable. The same outcome followed decades of investors avoiding so-called sin stocks – alcohol, tobacco, firearms, and gambling. Investors sacrificed returns but failed to end alcohol and tobacco use, gambling or gun purchases.
As a broad thesis, it’s best to assume that products and services that can be legally and profitably delivered will be, no matter how much others disapprove of them. This includes fossil fuels. The production of goods and services declines when people stop buying them – not when others stop investing in the companies that produce them.
The production of goods and services declines when people stop buying them – not when others stop investing in the companies that produce them.
Muddled ESG scores
So, what needs to change about ESG investing? Composite ESG scores – which attempt to summarize all material ESG risks into a single number or grade – convey little actionable investment information. “I have not seen circumstances where combining an analysis of E, S and G, across a broad range of companies with a single rating or score, would facilitate meaningful investment analysis that was not significantly overinclusive and imprecise,” said former Securities and Exchange Commission Chairman Jay Clayton in damning remarks in March 2020.
A case in point: Tesla’s current ESG scores by two leading rating agencies are below Pepsi’s. Does this mean electric vehicles are worse for the planet than soft drinks, or should socially concerned investors overweight Pepsi and underweight Tesla in their portfolios? And how should one account for all the single-use Pepsi plastic bottles littering the globe?
ESG ratings are all over the map because the underlying assumptions, methodologies and data inputs vary widely among ESG rating agents. Credit and ESG ratings illustrate how much work lies ahead for ESG analytics. Broadly accepted financial accounting practices have enabled competing rating agents – such as Fitch, S&P and Moody’s – to reach similar credit evaluations 99% of the time.
The same can’t be said for their ESG counterparts, such as MSCI and Sustainalytics. In a recent paper, researchers Florian Berg, Julian Kolbel and Roberto Rigobon found ESG scores among leading rating agencies correlated only 54% of the time – or barely one in two.
Failed ESG disclaimers
At the end of long advertisements for popular sustainable investment funds, you’ll often find a statement like the following: “There is no guarantee that any fund will exhibit positive or favorable sustainability characteristics.”
If so, what exactly is their point? We pay more for organic food precisely because we believe it has desirable, verified characteristics.
If sustainable investment funds can’t exhibit favorable sustainability characteristics, they should be called something else.
Impact investors expect their capital decisions will create outcomes that wouldn’t have existed otherwise. They are trying to improve the status quo.
ESG funds should be held to the same standard
If sustainable investment funds can’t exhibit favorable sustainability characteristics, they should be called something else.
Many ESG funds are not living up to their promises. Asset owners should make more discerning demands. ESG product regulations like those now in effect in the EU should also be embraced in other jurisdictions. Investors have the right to know what their assets are and are not likely to achieve. Asset managers should promote greater transparency, so their clients can readily make informed choices.
Focus on impact for real impact
Investors seeking to do well and good should consider reallocating capital from ESG-indexed products toward an emerging class of impact strategies with more verifiable social and environmental benefits. They won’t be disappointed if they look hard enough; there are hundreds of “impact investing” strategies that could generate actual double bottom lines.
