Growing public awareness of the climate crisis has boosted sales of ESG funds in the last few years. The disruption caused by Covid-19 in 2020 has accelerated the sector’s growth as investors look for sustainable business models that can withstand market shocks. According to Morningstar, funds that invest according to ESG principles attracted net inflows of $71.1bn globally between April and June of 2020, increasing assets under management in the products to a new high of just over $1trillion.
ESG (Environmental, Social and Governance) Investing refers to a class of investing that takes into account the three factors of environment, social impact and corporate governance when deciding which companies to invest in. Similar approaches to ESG Investing are Socially Responsible Investing (SRI) and Impact Investing. SRI Investing started in the 1970s as investors predominantly used negative screening methods to exclude investments in guns, tobacco, gambling, adult entertainment and other ‘vices’. Investing in these ‘vice’ stocks could be considered unethical as it appears to support morally “bad” or socially irresponsible businesses.
ESG investing can also be seen as an ethical choice in that it selects companies which, for example, are low carbon emitters and therefore do not damage the environment or which have good labour policies such as paying workers a good income. However, the motivation for ESG investing goes beyond ethical considerations as investors look for companies that have longevity and hence are more likely to outperform their peers over the long term. This could be because they are better positioned to take advantage of trends such as government regulation to reduce carbon emissions or because they are more likely to avoid regulatory penalties arising from oil spills or cheating on exhaust emission figures.
Impact investing is investing with the intention to generate a positive and measurable social and environmental impact alongside a financial return. It is not investing to avoid harm, for example by divesting from weapons manufacturers or fossil fuel producers. Instead, it takes a more positive stance and seeks investments which deliver benefits to society, whether in renewable energy, social housing or clean water.
All of these approaches to investing bring challenges with perhaps the most important challenge being lack of consistency in measures of companies’ (funds) ESG credentials. A number of rating agencies have emerged to provide ESG scores for companies and funds. These include MSCI, Morningstar and Sustainalytics. However, a number of academic studies have found a high level of divergence between the scores given by the different ratings agencies. One study found the correlation between ESG ratings from 5 agencies to be 0.61. This is in contrast to credit ratings provided by Moody’s and Standard and Poor’s where the correlation is over 0.9. This lack of consistency is partly because of a divergence in what should be captured in the ESG rating (scope divergence) and partly because of different weights given to different ESG criteria (weight divergence). This divergence is understandable as ESG ratings are a new industry. There is also the problem of unreliable data, for example, Boohoo was deemed to be a sustainable company by many ESG funds until the recent revelations of poor working practices at some of its clothing factories.
ESG data and ratings providers are currently unregulated, unlike counterparts focused purely on financial information. Nevertheless, efforts are being made to bring more transparency and standardization to the industry. A new European Union classification system for sustainability is set to be enforced by the end of 2022. This will introduce disclosure requirements for index and benchmark providers that use “sustainable” and other labels. It is hoped these new obligations will push the industry toward a higher-quality standard. However, ratings providers say their systems will improve significantly only if companies worldwide are forced to report relevant sustainability data. The EU currently requires large companies to regularly publish reports on the social and environmental impacts of their operations. The China Securities Regulatory Commission is making it mandatory for all listed companies and bond issuers to disclose ESG risks by 2020. But the U.S. Securities and Exchange Commission does not require corporate disclosure of material ESG data. While some companies may voluntarily disclose ESG data, there is not an enforced standard on how they should do it.
Traditional ESG investing has taken an active approach with investments selected to carefully meet a client’s preferences. It is argued that human input is required to precisely meet a client’s ethical preferences. This argument is perhaps more compelling given the problems noted above in relation to inconsistency of ESG standards. However, there is growing use of passive funds, particularly ETFs, for ESG investing. According to Morningstar, the passive BlackRock ACS World Low Carbon Equity Tracker fund saw net inflows of £700m in January 2020, the largest single ESG investment. A passive fund tracks an index that is specifically designed around ESG criteria. For example, MSCI have created three types of ESG indices: ESG integration, Values and Screens, and Impact. These mirror the 3 types of sustainable investing described above i.e. ESG, SRI and Impact.
One advantage of passive ESG investing is the low cost. Some passive ESG ETFs have OCF’s of between 0.1 and 0.2%. A disadvantage of passive ESG investing is that it is not possible for a fund manager to constantly monitor every single holding in the fund. Most passive funds do not have the resources to undertake this analysis. This leaves the fund open to criticism of investing in a company that does not meet important ESG criteria. A good example of that is the aforementioned BlackRock ACS World Low Carbon Equity Tracker fund which invests in Nestle which for many ethical investors is not a good ESG company because of its association with various water scandals.
The debate about whether ESG investing can ever be carried out using a tracker fund will continue for some time. Proponents of active only ESG investing will argue that this approach is the only way to guarantee a pure ESG portfolio. However, the lack of disclosure of information by companies will still cause problems for an active approach. In the meantime, low-cost, well-marketed passive ESG funds will continue to attract a growing number of investors who want to invest in this space. These investors may be willing to sacrifice having a pure ESG portfolio for one that is a little less than pure but at a lower cost.
At Crossing Point, we offer Greenpath portfolios1 built using ESG integrated and ethical funds and ETFs to create diversified portfolios. The underlying funds contain multiple investments, selected by the fund providers according to their strict ethical screening processes. All of the fund providers have signed up to the Principles for Responsible Investing. Our careful fund selection criteria involve the use of ESG ratings provided by both Morningstar and MSCI. The funds are largely passive funds that track an ethical index although some of the funds engage in active management to ensure an ethical position is maintained.