Seeking investments to do good, not just to do well, has been gaining popularity as a wealth management approach. Luckily, as ESG funds grow up, this goal is also becoming more practical.
A growing number of mutual funds and exchange-traded funds focus on “environmental, social and governance” criteria, commonly abbreviated ESG. These funds allow investors to concentrate on companies that meet particular benchmarks. Environmental factors may include the company’s emissions, waste management, or natural resources and energy use. Social criteria generally involve the company’s actions toward employees, vendors, customers and community. Governance concerns include diversity among a company’s leadership, executive pay relative to compensation throughout the business, and accounting transparency.
Given the wide spectrum of concerns that can fall under the ESG heading, fund managers can take a variety of approaches to selecting investments. Whether a given company passes ESG tests may differ between investment firms, or even between funds in the same firm.
There are also other responsible investment strategies for investors who want a narrower focus. “Sustainable investing” usually refers to a concentration purely on environmental concerns. “Socially responsible investing” is the practice of investors avoiding either industries they find undesirable, such as firearms, or industries that engage in undesirable social practices, such as manufacturers with opaque supply chains that could involve exploitative labor practices. “Impact investing” is meant to balance financial returns with a positive social or environmental impact. This approach may focus on areas such as renewable energy or affordable housing that involve both a social good and, ideally, substantial financial growth.
The growing diversity of responsible investment and ESG options reflects consumer demand. While this style of investing has existed in various forms for decades, ESG investments labeled as such took off in the United States after the 2016 presidential election. They have not flagged since. Reuters reported that, as of the end of November 2021, a record $649 billion in assets were held in ESG funds worldwide. As of that report, ESG funds accounted for 10% of global fund assets. According to Bloomberg, ESG assets increased 25-fold between 1995 and 2020, and tenfold between 2018 and 2020 alone.
This growth is likely to continue. BlackRock, Inc. performed a global investor survey in mid-2020 that found respondents planned, on average, to double their sustainable assets under management in the five years to follow. Some analysts project that overall assets in ESG funds will exceed $50 trillion in the next two decades.
ESG investing is undeniably popular. But is it a good idea?
As recently as 2018, I observed that Palisades Hudson’s advisers typically recommended against ESG investing. At that time, my colleagues and I instead suggested that clients invest in a diversified portfolio and donate a portion of the returns to organizations that pursued their environmental or social goals. In some cases, this is still the most appropriate tactic. But in the intervening years, some of the drawbacks of ESG funds have decreased. In other cases, investors are more aware of them.
One major downside of ESG investing is the potential for lower returns. In some cases, investors may be fine with this outcome, deeming it a worthwhile result of supporting companies with sustainable or socially responsible practices. But a recent spate of enthusiasm, especially for green energy, has tempted some ESG investors to think they really can have it all when it comes to sustainable investing.
The pandemic added an additional lure, as ESG funds were largely resilient during the volatility of the past two years compared to traditional funds. However, investment professionals fiercely debate whether there is any evidence for the idea that ESG funds will outperform traditional funds over a longer time frame. ESG funds typically underweight energy stocks, which have underperformed in previous years, and overweight tech stocks, which have outperformed. As a result, some enthusiasts have argued that investors can count on ESG funds to outperform broader markets over the long term. While short-term studies have shown positive results for ESG funds as a class, it remains unclear whether those trends will continue.
A recent series for The Wall Street Journal argued that the case for high ESG returns is, at best, temporary. James Mackintosh wrote, “A company doing everything right on ESG might still be wildly overpriced; an all-male, all-white coal-mining-to-tobacco conglomerate run by Dr. Evil could be so cheap as to be a great—if unpleasant—investment.” If, for example, companies are leaving fossil fuels in the ground, someone will have to take a loss somewhere. Mackintosh suggested that ESG investors and fund managers just generally hope it will be someone else.
The primary reason for investors to pursue an ESG investment strategy is that they believe ESG goals matter. For many people, this reasoning is self-evident. Yet recent marketing for many ESG funds tilts toward the potential financial benefits. The broad idea, especially in environmental investing, is that many actions that are legal right now will likely become illegal in the future. Investing in companies that already do less polluting, for instance, will give you access to higher profits in the more-regulated future. This may or may not turn out to be true. But certain ESG investors take it as an act of faith.
At Palisades Hudson, we advise our clients to expect ESG performance to be cyclical. ESG funds will outperform in some years, thanks to their underlying composition and industry over- and underweightings. In other years, they will underperform. Over the long term, we can’t claim that ESG funds will consistently outperform traditional funds. But we expect that investing in diversified ESG funds, and building a portfolio of ESG funds with exposure to different countries, industries and company sizes, will yield long-term returns similar to a market portfolio, without the kind of significant deviations that a more concentrated portfolio could create.
Apart from questions of performance, investors must bear in mind additional costs associated with pursuing an ESG strategy. ESG funds, whether they are passively or actively managed, typically charge more than similar funds that do not incorporate ESG screening or methodology. However, much of the recent growth in ESG investing has taken place through passively managed exchange-traded funds, some of which charge fees that are quite reasonable. For example, Vanguard’s ESG U.S. Stock ETF charges an annual expense ratio of 0.09%. While this is higher than the 0.04% annual cost of Vanguard’s S&P 500 fund, the difference in the funds’ underlying holdings will have a much greater impact on their comparative returns than their respective fees.
The good news for investors who value ESG criteria is that growth in investor demand has not only led to falling costs and more funds to choose from, but also to improved analytics for these funds. This data, much of which did not exist before, reduces (though does not fully eliminate) the risk of greenwashing: funds offering false or misleading impressions of their underlying investments, especially regarding environmental impact. Companies including Bloomberg, S&P Dow Jones Indices and MSCI offer ESG ratings for individual companies. These ratings generally follow a 100-point scale, with higher scores illustrating better performance on ESG criteria.
Sustainalytics, which has been part of Morningstar since 2020, is among the principal providers of ESG-related data. The company offers detailed ratings to institutional investors and public data for more than 2,000 companies via Yahoo Finance. Its approach is two-pronged: Analysts consider companies’ exposure to various ESG factors and the ways those factors create financial risk. This means Sustainalytics looks at a company’s track record on issues such as managing emissions or navigating management controversies. It also evaluates a company’s environmental and social impact relative to its costs and risks. These ratings are absolute, rather than relative to a company’s industry.
In addition to investor analytics, more regulatory scrutiny may help to reduce the risk of greenwashing or to eliminate other opacity in the ESG fund selection process. The U.S. Securities and Exchange Commission can, and does, examine investment firms’ disclosures to ensure that ESG funds follow the strategies that their investors expect. In April of last year, the SEC formed a task force to focus specifically on ESG issues. The commission is also working to develop standardized reporting requirements for corporations, which would make it easier to measure a company’s impact on climate change specifically. It recently proposed new rules to this effect.
This movement from U.S. regulators follows tightened European regulations, some of which fully took effect in January. As I wrote in this space last year, European Union regulations now require financial institutions that offer ESG funds to disclose exactly how fund managers evaluate the objectives central to the funds. By 2023, the EU’s Corporate Sustainability Reporting Directive will also come into force. Once it does, European companies will need to publicly disclose certain sustainability metrics.
Further, the International Sustainability Standards Board, created at the 2021 COP26 summit in Glasgow, may release a draft of proposed global sustainability disclosures this year. The ISSB does not have the authority to mandate such requirements, but it could establish a global baseline of disclosure standards. If major economies including the EU and the U.S. buy in, such standards could make it much easier for investors to compare companies’ ESG ratings.
The Future Of ESG
While much of the future of ESG investing is not clear, it is safe to say that the trend is big and here to stay. According to a 2019 survey from Morningstar, 72% of American adults expressed at least moderate interest in sustainable investing.
At Palisades Hudson, the firm’s Investment Committee has developed diversified ESG portfolios and, separately, low-carbon portfolios. These portfolios provide exposure to each asset class we recommend similar to the exposure provided by a more traditional portfolio. The sustainable portfolios use a mix of funds with dedicated ESG strategies, as well as funds without ESG strategies whose holdings rate highly according to sustainability metrics and analytics. While we do not recommend ESG investing for everyone, the committee agreed that the growth in ESG investment options had reached a point where we could satisfy client demands for more sustainable portfolios without sacrificing much in terms of potential returns or higher expenses.
Some analysts suspect that the line between ESG and traditional investing may continue to erode. Todd Cort, co-director of the Yale Initiative on Sustainable Finance, told FastCompany that many – if not most – actively managed funds now consider climate risks to some degree for financial, rather than ideological, reasons. “It’s hard now to find any kind of fund that doesn’t consider climate risks in some way, shape, or form,” Cort said in December. BlackRock, the world’s largest asset manager, announced in 2020 that it would make environmental sustainability central to its portfolio construction and product design. CEO Larry Fink emphasized that this decision was based on the belief that the change would create better financial outcomes for BlackRock clients in the long term.
Certain critics of ESG investing point out that it may be a distraction from other tools for creating environmental or social change. Regulation, taxation or subsidies may be more effective on a communal level. For individuals, donating to nonprofits or even providing capital to green startups, for those in a position to do so, could make a larger difference. But for many investors, ESG investing is a supplement to other ways to support their goals, not a replacement for them.
As this article suggests, there are a variety of ways to pursue sustainable or socially conscious investing. Depending on your priorities, you may choose to make a blacklist of no-go industries, such as coal or tobacco. You may accept that all publicly traded companies have some flaws, but prioritize funds that include the least bad options when it comes to sustainability or governance. If you are more of a glass-half-full type, you may want to seek out funds including companies whose work actively excites or inspires you. Or you may want to focus on fund managers who will influence policy through proxy votes, especially if you prioritize governance over other concerns. All of these are valid approaches, and all of them will become easier as companies and financial institutions offer more data to the public.
If you’re curious about ESG investing, talk to your financial adviser. It is not right for everyone, but if the underlying concerns matter to you, you’ll find that achieving your goals has become much more realistic over the last few years.