ESG Investing - Is it really all it's made out to be?

ESG investing: is it really all it’s made out to be?

ESG investing is very much in vogue now and has been gaining in popularity and importance over the last few years. However, there have been increasing calls for reassessment lately. 

Environmental, Social and Governance. ESG. But what does it really mean and how can it be done efficiently and successfully? That is the question. At its core, nobody can knock the intention of ostensibly investing in companies that are good (or at least better) for the planet and society’s wellbeing. However, there are many nuanced arguments both for and against this approach. 

First let us analyse what is ESG investing?

In its simplest terms, it is investing in companies that are looking to make the world a better place. It allows people to try and align their personal values with their investment choices. This is of course admirable. ESG provides a set criteria against which we can consider how well public companies safeguard the environment and communities where they work, as well as how effectively and efficiently they ensure management and corporate governance meet high standards. Ultimately, it is an assessment of non-financial factors prior to making an investment decision. At its best it can provide an investor with a more holistic view of how a company operates, which, in turn, can mitigate risk and identify opportunities for profit. 

What does the acronym represent?

Environment - what impact does a company have on the environment in terms of its output? This can include its carbon footprint, its usage of chemicals in the manufacturing process, as well as its pursuit of sustainable processes throughout its supply chain. 

Social - how does a company improve its social impact, both internally and within the wider community? Social factors include LGBTQ+, equality and racial diversity, both within the executive suite and staff overall, and inclusion measures and hiring practices. It can even look into how a company advocates for social good in the wider world, beyond the scope of their business. 

Governance - how does a company’s board and management drive positive change? Governance includes an array of issues ranging from executive level pay to diversity in leadership roles, as well as how well that leadership responds to and interacts with shareholders. 

Does it work?

This is open to debate. In terms of pure performance, there have been numerous studies compiled over the last 12 months that show there is at best no advantage of investing in ESG funds and at worse a discernible disadvantage. One such study, by Research Affiliates, tracked six ETFs over a four year period which showed the one with no ESG overlay saw a similar performance to the other five. Likewise a study from the Journal of Finance, which found that out of a pool of 20,000 mutual funds with USD 8 trillion in assets, those rated highly for ESG factors did not outperform those rated poorly by that metric. There are, however, many reasons for this, which creates a challenge in making concrete conclusions regarding performance. In a combined study assessing the adoption or otherwise of ESG measures, researchers from Columbia University and the London School of Economics showed the ESG record of US companies in 147 ESG fund portfolios against that of 2,428 non-ESG portfolios. They found that companies within the ESG portfolios had worse compliance records for both labour and environmental rules. They also found that companies added to ESG portfolios did not subsequently improve their compliance with labour and environmental regulations. This poses the question: why bother? 

Before we assess the perceived criticisms, let us look at the figures. By the end of 2021, assets under management at global exchange-traded sustainable funds that aim to meet ESG standards totalled more than USD 2.7 trillion. Of this, 81% were in European-based funds and 13% were in US-based funds. Interestingly, 18 months later by the end of May 2023, Fintech Global had found that there were approximately 7,030 ESG investment funds around the globe, though the total value had not increased in that time. This is possibly backed up the by data and opinions of the investment managers and advisors, who are torn on its efficacy. The Association of Investment Companies’ 2022 study showed that only 4 out of 10 investment managers think ESG is likely to lead to a better investment performance. In a similar study, 56% of Discretionary Fund Managers agreed when surveyed by Research in Finance last year. There is a strong sentiment among investment and wealth managers that it is perhaps more of a ‘feel-good’, rather than a profitable, investment strategy. 

Among the most level-headed criticisms of ESG investing are the claims that it is subjective, redundant and it sacrifices returns. At its most severe, there are claims that is is ostensibly virtue-signalling or indeed ‘woke’. This is becoming more and more prevalent in the USA, where President Biden used his first presidential veto to defend a rule on ESG investing; a rejection of a Republican proposal to prevent pension fund managers from basing investment decisions on factors like climate change. Such is the extent and level to which this topic is considered and debated. 

Then there are the claims of ‘greenwashing’ - making false or deliberately misleading statements about the environmental benefits of a product or company. Indeed, one of the biggest advocates of ESG, the so-called ‘Godfather of ESG’, Larry Fink, Chief Executive of US Fund Management company BlackRock, this week told a panel in Aspen that he was no longer going to use the term because it is being politically ‘weaponised’. 

There is also the consideration that ESG ratings overlook some key factors. Often they omit important behaviours and choices, particularly corporate political activity, in other words political lobbying and dealing: but how can this be measured? We already know how hard it is to detect and prevent…

by Charles Glover

Disclosure: This article has not been written to give advice, and purely expresses our own opinions. We are not receiving any compensation for it, and we are not responsible or liable in our capacity as an independent financial adviser for any action taken by readers based on these opinions. For personalised advice based on these issues, please seek advice from a regulated, independent expert.