Many investors want more than long-term growth from their portfolios. A growing class of funds offer investors the opportunity to make investment choices that align with their values – but when it comes to nailing down the specifics of those values, things can get murky.
ESG stands for “environmental, social and governance” criteria. Mutual funds or exchange-traded funds with an ESG focus offer investors the opportunity to invest in companies that meet these particular criteria. Environmental factors may include emissions, natural resources or energy use, and waste management. Social factors may involve labor practices, community impact and worker safety. Governance focuses on issues like board diversity, executive pay and accounting transparency. Investing in ESG funds allows investors to choose funds that focus on more than a company’s economic performance.
Socially conscious investing, especially via ESG funds, has grown in popularity in recent years. Global assets invested in sustainable funds surpassed $1 trillion last year, according to data from Morningstar. Money managers launched 71 sustainable mutual funds and ETFs in 2020, a new annual record. According to data from US SIF, assets under management with ESG or other socially responsible investing mandates increased almost 40% between 2016 and 2018 alone.
ESG investing is growing, but it is not brand new. Its precursor, “socially responsible investing” or SRI, arose as an investment strategy in the 1960s and ’70s. At first this strategy mainly focused on avoiding certain companies, in contrast to modern ESG strategies which seek out sustainable enterprises. SRI investors often chose divestment as a way to show their disapproval of a company, sector or even a nation. For example, widespread divestment from companies tied to the apartheid regime in South Africa exerted economic pressure on a government many outsiders condemned. Other investors chose not to invest in companies tied to the tobacco industry as the health risks of smoking became better known. Avoiding certain companies and industries is still a concern for some investors, but today ESG funds are a more popular approach for those who want their principles to shape their portfolios.
However, as ESG funds grow more popular, a question remains: What exactly qualifies a fund for the ESG label? Companies including Bloomberg, S&P Dow Jones Indices and MSCI offer ESG ratings for individual companies. These scores often fall on a 100-point scale, with higher scores showing better adherence to ESG criteria. But those criteria are not standardized. As a result, scores can vary due to differing metrics and the way research companies weight them. This can lead to different ESG funds including very different companies, including some an investor might find surprising.
One of the most controversial areas for ESG investing is the degree to which ESG funds include large tech companies. Morningstar data released in 2020 revealed that eight of the 10 best-performing ESG funds focused on large U.S. companies had their biggest holdings in Apple, Amazon or Microsoft. Holdings in Facebook and in Google parent Alphabet are also common. Criticisms of anti-competitive practices, mistreatment of some workers, or the energy required to support the internet’s infrastructure might seem to disqualify one or more of these companies. On the other hand, Facebook gets more than 75% of its energy from renewable sources; Microsoft is known for its commitment to treating employees well; and Apple recently pledged to tie executive bonuses to adherence to the company’s social and environmental values. Without rules determining what qualifies a company for inclusion in an ESG fund, the decision rests with individual firms or fund managers. Critics claim that managers are simply justifying including tech giants to make sure their funds perform well, regardless of sustainability. This argument remains hard to disprove without solid guidelines for how companies qualify.
This is not to say ESG labeling is a free-for-all. The U.S. Securities and Exchange Commission can examine investment firms’ disclosures around sustainable funds to ensure that they are not misleading investors about their strategies. The SEC announced in March that it would increase such examinations this year. But this scrutiny only confirms that investment managers are not deceiving anyone. There is no industry-wide standard for what an ESG fund looks like. Instead, a patchwork of voluntary frameworks and information gathered by private data firms govern disclosure.
Investors may soon gain some clarity. The European Union is taking steps to increase funds’ transparency and to try to institute some quantifiable guidelines for sustainable investing. If regulators succeed, these best practices may extend beyond Europe to make ESG a more descriptive label than it currently is.
Fund managers who raise money in the EU and claim any socially conscious aspect in any of their financial offerings must now disclose exactly how they address ESG considerations. The disclosure must lay out specifically how fund managers evaluate the characteristics or objectives central to the fund. Managers are required make these disclosures both at the entity level and at the product level (that is, for individual mutual funds and ETFs). Banks, private equity firms and other asset managers must also meet related disclosure requirements for all their funds, regardless of whether they have marketed them as “sustainable.”
Most substantive portions of the regulation came into force March 10, 2021. Certain required disclosures must be implemented no later than Jan. 1, 2022. The EU also plans to update reporting requirements for all companies, not only financial firms, to require broader governance reporting. Companies may need to detail anti-bribery and corruption practices, as well as their approach to respecting human rights (for example, steps taken to avoid working with suppliers who use slave labor). Such mandated disclosure will help to make a company’s ESG credentials clearer to investors.
One of the main goals of the new regulation is to cut down on “greenwashing.” This term refers to funds that allegedly offer false or misleading impressions about their focus on environmental factors. Regulators hope that requiring greater transparency will force investment firms to put their stated principles into practice. This is not to say every firm must score perfectly on ESG criteria. The EU’s new approach rests on the idea of “Do No Significant Harm.” The idea is to measure environmental sustainability in relative terms, and to provide companies and investors flexibility in pursuing environmental goals. For example, burning natural gas creates less pollution than burning coal, even though it still generates some greenhouse gases. The EU’s “Green Taxonomy” lets stakeholders consider the relative merits of a project or company’s environmental impact without demanding no impact whatsoever.
For now, the European rules only apply to any firm that offers financial products in the EU. They do, however, apply regardless of where that company is based. The realities of global finance mean that these rules are likely to impact practices well beyond Europe. Major American investment firms like Vanguard, BlackRock and State Street all sell investment products in the EU. With other major economies including the U.S., Japan and the United Kingdom reportedly considering their own ESG disclosure rules, the EU’s regulation may be the first step toward a new industry standard.
While the regulation-heavy EU can often frustrate outsiders, this is an area where a bit of sunlight could do some real good. Yes, the rules will need to remain at least a bit fluid. But that would hardly make them unique.
Some observers have compared the EU’s Green Taxonomy to standards that finance chiefs already use, such as generally accepted accounting principles, or GAAP. It’s a useful comparison. Accounting rules are, by their nature, sometimes subjective. They may also change to reflect shifts in business practices or other industry norms. For example, in the early 2000s, the Financial Accounting Standards Board triggered significant debate when it proposed that companies be required to deduct the value of employee stock options from their profits. Opponents said that making expensing options mandatory would hurt small businesses and startups. Supporters pointed out that permitting companies not to expense options distorted outsiders’ view of the company’s profitability. In 2005, the FASB made expensing options mandatory, ending the debate. Regardless of your view of the question, resolving it meant that everyone was working on a level playing field, letting potential stakeholders compare apples to apples.
There are still kinks to iron out in ESG reporting requirements, too. Some fund managers have pointed out that the EU regulations sometimes ask for information companies have not disclosed. Self-reported data may not be accurate in the absence of a mechanism for outside review. And some of the specific measures European regulators want may not even be data companies have collected before now. But much like uniform accounting rules, a broad move toward consistent reporting requirements could help investors draw accurate comparisons. As Jeff McDermott, head of Nomura Greentech, a New York-based investment bank, put it: “If some companies reported their sales whenever they shipped from a warehouse and some when cash was received, it would be completely impossible for an investor to say which is a good company. We don’t have this today for ESG.”
Even if new regulations make ESG parameters clearer, investors should remain aware that these funds can involve trade-offs. On the whole, ESG funds incur higher fees than standard mutual funds and ETFs. According to data reported by The Wall Street Journal, the average fee for ESG ETFs was 0.2% at the end of 2020, compared to 0.14% for standard ETFs investing in large-cap U.S. stocks. Actively managed ESG funds also tend to charge a premium. While these differences can seem small, higher fees can eat away at earnings over time. At Palisades Hudson, my colleagues and I have often advised clients concerned about environmental causes that they may do more good investing in standard funds and donating the proceeds to environmental organizations. Still, a particular ESG fund may have a reasonable place in a diversified portfolio. It will be easier to make that argument when investors can clearly understand what makes a fund worthy of the label.
As the trend toward ESG funds continue to grow, investors have had to try to determine what the label means for any given fund. Right now, investment companies, and sometimes individual fund managers, define it for themselves. If investors truly want ESG funds, they would benefit from a consistent understanding of what the label means. Solving this sort of question with regulation will always be complex, but at least the EU is making a reasonable start.