If ESG Investing Feels Good…Do It!

Summary

• ESG investing is the hot new concept in asset management. But there is little convincing evidence that it makes a difference.
• Research to date has found no clear link between ESG investing and investment performance, nor evidence that ESG investing is a distinct factor or investment style.
• Investors aren’t convinced – the largest broad market ESG ETF is only about 5% of the SPY ETF that tracks the S&P 500.
• One shortcoming is that ESG scores rely largely on information that companies provide, with little effort to audit whether they comply with their standards and objectives.
• Another is that ESG scores today provide little hard information on the change that investors and regulators will increasingly look for, such as company emissions or exposure to climate change.
• Substantive progress on this front may await more formal ESG standards.

Environmental, social and governance (ESG) investing has become the hot new concept in asset management in recent years. Indeed, a 2017 survey by the CFA Institute reported that 73% of portfolio managers take ESG issues into account in their investment process. And many companies are trying to rearrange their profiles – and maybe even their operations – to raise their ESG scores But a lack of standardisation and little clear evidence that it improves investment performance raises the question whether it is worth the hype?

What Is ESG?

The ESG concept has existed for at least 20 years, but it only caught fire over the past decade . The idea is to evaluate companies across three nonfinancial dimensions:

• Environmental: impact on climate change, use of green energy, minimization of pollution and waste products
• Social: community relations, health and safe working conditions, human capital development
• Governance: transparency, management, ethics, accountability

ESG vendors assign scores to each dimension and its subcomponents, then combine the values into a single composite score that is comparable across companies. In other words, they take something difficult to describe – at least succinctly – somehow quantify it, and then boil it down to a single number.

Another way to characterize ESG investing is by investor objective. One approach is using ESG ratings to improve the risk/return of a portfolio. Another is to create a portfolio aligned with the investor’s beliefs, or values-based investing. Yet another is investing to achieve some social or environmental objective, such as diversifying boards of directors or reducing toxic manufacturing processes.

To put it another way, ESG means different things to different people.

Many ESG Vendors but Little Standardisation

According to Global Initiative for Sustainability Ratings, an organization that reviews and accredits ESG vendors, more than 100 vendors and agencies provide some form of ESG ratings. Major vendors that have been in the ESG rating business for a decade or more include MSCI, Sustainalytics, Thomson Reuters, and RepRisk. More recently, Bloomberg and Standard & Poor’s Global started publishing proprietary versions of ESG ratings, and Moody’s is now incorporating ESG criteria into its company and sovereign credit ratings methodologies.

Each vendor has its own methodology for evaluating and scoring ESG. Consequently, ESG scores can vary across vendors, putting the onus on investors to determine which one or ones meet their needs.

A primary source for ESG vendors is information that the company provides through publicly available documents (e.g., financial reports, press releases, and regulatory filings) and, in some cases, surveys conducted by the vendor. Some vendors supplement this with information gleaned from articles in the press or comments and blogs on the internet.

Vendors largely tend to focus on what the company says its ESG-related goals and objectives are. Often, little information exists on whether or to what extent companies actually meet their stated objectives. Indeed, it is likely that companies that want to improve their ESG rating can ‘game’ the system by making superficial rather than substantive changes.

The major vendors provide varying degrees of information about their ESG ratings for companies on their public websites. They typically provide the overall score and a general description of their methodology. Some provide more information than others about how the E, S, and G components contribute to the overall score, but investors who are primarily interested in some aspect of ESG – e.g., governance, or carbon emissions – will generally be unable to find more detailed information on the vendors’ public websites. More granular data and information may be available to subscribers, but we are not in a position to verify that.

The International Accounting Standards Board (IASB) has started an effort to develop more standardised criteria to define and measure ESG. It is currently unclear how they will proceed or what kind of framework they may propose.

Does ESG Make a Difference?

A wide range of studies has tried to determine whether ESG investing improves portfolio performance. Another line of studies has tried to analyse whether ESG is a distinct investing factor (like momentum, firm size, and growth) that can produce alpha. Vendors or practitioners produce many of these studies, and few go through peer review.

To broadly summarise, the results so far are inconclusive. Some report that ESG investing makes a difference; others the opposite; and others are simply inconclusive. Even when studies show a correlation between ESG investing and performance, showing causation is generally impossible (i.e., that good performance resulted from ESG investing and not some other factor).

MSCI published research on its MSCI ESG ratings in the Journal of Portfolio Management, which generally showed ESG investing made some difference. For example, highly rated ESG companies were less likely to experience downside shocks, were more profitable, paid higher dividends, and tended to have less volatile share prices. The research also shows that companies with an ESG rating that changed up or down tend to see better or worse stock performance in subsequent years.

After reviewing this article and various other material, it is clear that ESG scoring and investing is about finding good companies – essentially those better at defining a strategic vision and managing their risks. But it is unclear that ESG investing is distinct from following, for example, the criteria that Benjamin Graham or Warren Buffet use to find good investments. In the CFA Institute survey of investment professionals referenced above, many said they focused primarily on the governance dimension. But haven’t they always paid attention to governance as part of the investment process?

Bottomline – much of ESG is really about a way to try to standardize and quantify information rather than a new or better way to gain insight.

So, You Want to Do Some ESG Investing

For investors interested in ESG investing, there are two basic routes. Either buy stock or bonds in the companies that reflect their ESG objectives or invest in ESG-oriented ETFs.

At least 250 ETFs exist. Most are small (with assets in the millions or low tens of millions of dollars) with high expense ratios. The largest is the broad market iShares ESG Aware MSCI USA ETF (ESGU) with $17.4bn in assets, but that is a minnow compared to SPY, which tracks the S&P 500 and has $366bn in assets under management.

ESGU tracks the ESG Aware MSCI USA Index, which seeks to maximize exposure to companies with favourable ESG characteristics. It excludes various sectors and companies that may be controversial or subject to significant business risk, including companies with significant exposure to alcohol, gambling, nuclear power, conventional and nuclear weapons, civilian firearms, and tobacco. It further is optimised to track the MSCI USA Index. Almost by definition the ESGU index is unlikely to out- or under-perform the broader market by much. Little wonder that it is difficult to determine whether ESG investing enhances investment performance.

The investor must decide whether the ESGU mix meets their goals. Investors who go the ETF route may well end up doing as much research as if they invested in individual companies that meet their ESG criteria.

Today’s ESG Is Hardly the Wave of the Future

ESG investing has a certain patina of respectability and political correctness. But when you look under the hood, it is hard to see what all the excitement is about.

From our standpoint, ESG investing has at least three major shortcomings. First is the lack of clear evidence that ESG is a distinct alpha-generating investing factor. It is difficult to argue that it is not just a proxy for other factors. For what it’s worth, investors aren’t beating down the door to buy ESG-oriented ETFs.

Second, much of the ESG scoring process is based on what companies say about themselves. There is little if any standardization in how ESG-type information is reported, and little effort to audit companies to see if they comply with their standards.

And perhaps most importantly, it is unclear that ESG scores as currently constructed will provide the kind of hard information investors and perhaps regulators will be increasingly looking for as climate change issues and decarbonization increasingly come to the fore.

Substantive progress on this front will probably await more formal ESG standards. It will be interesting to see if the IASB effort to create ESG standards addresses these issues.