Catherine Child.6 January 2020

ESG funds are on the rise – or are they?

ESG investments have seen impressive growth in recent years however this has also brought growing concern over the lack of transparency in many ESG funds.

A 2019 report by WSJ shows that a staggering 80% of the largest US ESG funds are still investing in Oil and Gas companies. This opens the question of whether the core growth of ESG funds is driven by areas that conflict in value.

ESG investments have seen impressive growth in recent years however this has also brought growing concern over the lack of transparency in many ESG funds.

What are ESG Funds?

ESG stands for the Environmental, Social, and Governance policies of a company. There is no specific ESG criteria for companies – as the guidelines are hard to define – but these can be viewed as a set of standards for company operations. For example, companies that are active in social justice, environmental sustainability, clean technology, and well positioned for the future would score highly. ESG growth has had a positive impact in many countries driving new regulations, and  encouraging small or large companies to innovate.

While ESG investing stems from Socially Responsible Investing (SRI) there is one key difference. ESG operates through positive screening versus SRI’s negative screening. More simply, the investment is graded by what it can do rather than what it can’t do. There is no definitive list of values and criteria that the company must pass – instead value is realised through consideration.

Financial return vs Social good

ESG investing had always been criticised with the belief that investing with the intent of making a positive impact must mean growth or income will be sacrificed to some degree. This ‘myth’ has been strongly disproven and Morning Star’s mid-year report showed that the top performing ESG funds all gained around 16% over a 12-month period. Many investments have in recent times, even been praised for outperforming their non ESG peers. Ultimately, a good return does not need to be sacrificed in ESG funds, and the financial outlook must still be assessed! 

A question of regulation 

This flexible strength is also the sector’s biggest challenge. The lack of clarity regarding what exactly constitutes an ESG fund means that it’s particularly hard for interested investors to ensure the investments they make align with their values. Interpretations and analysis of ESG can often vary across different investing communities. For example, the ESG review of Tesla was extremely mixed: MSCI gave Tesla a nearly perfect score for ‘Environment’ due to the company’s emphasis on clean technology while FTSE gave it a 0 for ‘Environment’ for its Factory Emissions figures. 

This becomes even more dangerous when corporates deliberately exaggerate or misrepresent their ESG credentials which allows them to win investor support on false pretences. This is called ‘Greenwashing’ which is the miss-selling of an ESG fund – companies get away with this due to the lack of regulations.

This feeds into the fear that misleading ESG labels can result in large returns being skewed by the lack of transparency. If ESG funds hold significant positions in stocks that could be deemed unethical – such as big oil or tobacco stocks – but investors are unaware – the fund may be performing well for the wrong reasons. For example, an SRI fund from one of the largest Investment Management companies, still had 5.7% invested in alcohol, gaming, and defence stocks.

Unless clear metrics are introduced, ESG standards will continue to be applied selectively and mislead many investors who are trying to support social good. 

So why are people more interested in the ESG standards of companies they invest in? 

One reason is due to ESG aligning with many global initiatives like Climate Change. These days companies are all expected to release their initiative and stance for saving the world. This has received a lot of mainstream attention engaging more investors in ESG considerations before making an investment. A sustainable investment portfolio has become a necessity for those committed to initiatives and there have even been cases where investors do not want to be caught holding companies deemed to have harmed society.

Moreover, there is increasing evidence that proves companies who take ESG seriously are better companies. How a company operates is a major factor in investors’ buying decision, as those who are adopting practices that mitigate risk are safer bets. Experts now advise investors to consider ESG track records – as it is a good signpost for a specific company or fund. 

At the core, ESG investing promises a better working environment, a better world, and a society committed to social good. However, the lack of regulation which facilitates greenwashing is the big challenge that investors must overcome.