Environmental, Social, and Governance (ESG) has been a growing topic of discussion over the past year and we are seeing an increasing number of companies acknowledging the call for ESG reporting on top of their annual financial reports. Fund managers and institutional investments are also introducing investment products that incorporate ESG as an investment criteria.
But I am not sold with the idea of ESG investing just yet and I believe many retail investors aren't as well.
In this article, I share 4 reasons why retail investors like me are not ready to put our money into ESG investing today and what I think needs to be done to improve ESG investing.
What is Environmental, Social, and Governance
Environmental, Social, and Governance (ESG) criteria are a set of standards for a company’s operations that socially conscious investors use to screen and evaluate potential investment opportunities. The environmental criteria consider how a company performs as a steward of nature. The social criteria examine how the company manages its relationships with employees, suppliers, customers, and the communities where it operates. The governance criteria deals with a company’s leadership, executive structure and diversity, auditing processes, risk management, and shareholder rights.
I will not be explaining too much about what ESG is about (or my readers would complain that my article is too long again) because many websites and blogs have wrote about this subject already and if you want to have a good understanding about ESG, you can refer to this article from Seedly.
The chart below demonstrates a very simplistic view of how ESG rating looks like, broken down by pillars and their respective themes. In actual implementation, each theme has different weightage and is further dissected into a variety of data points per industry for measurement.
Now let's look at the reasons why I am not investing my capital into ESG investments today.
Lack of standardised ESG scoring criteria
Today, there are many ESG rating agencies such as MSCI, Sustainalytics, Vigeo Eiris, ISS, RobecoSAM, and Asset4. They play a major role in scoring a company's ESG performance and they do this by painstakingly collect and aggregate a wide variety of information spanning from corporate disclosures, third-party reports from organisations such as NGOs, news, and proprietary research through company interviews and questionnaires.
Through these efforts, rating agencies come up with an overall ESG score, as well as individual scores for Environmental, Social and Governance components separately.
It takes a lot of hard work and investigative research to rate a company for its ESG efforts and each ESG rating agency has their own way of execution. Unfortunately, that also results in ESG rating agencies having very differing ESG scoring criteria, methodology and standards. According to Eco-Business, The correlation between ESG ratings across different rating agencies is around 0.3, a stark contrasts with credit ratings, where the correlation between ratings by S&P and Moody’s is around 0.99.
The impact of inconsistent ESG scoring trickles down to investment products and platforms as fund managers and platform operators don't often use the same ESG rating agency to formulate their investment strategy and screening criteria. That results in investment funds that have the same investment objectives, investing in very different companies because one company may have scored a high ESG score with one ESG rating agency may have a poor ESG score with another ESG rating agency.
For me, this inconsistency and lack of standardisation simply means that I can't simply trust any ESG investment product without having to deep dive down into the specifics of ESG rating and methodology.
Difficult to differentiate real ESG efforts from greenwashing
As much as I love the entire ESG concept, we need to also recognise that there are unscrupulous individuals and companies who are repackaging their companies and investment products as being ESG-oriented when in reality, they are not.
Greenwashing is the practice of conveying a false impression or presenting misleading and exaggerated claims about environmental efforts. It leads people to believe that your company is doing more to protect the environment than it really is.
From the investor's perspective, it becomes a problem because it takes a lot more effort to scrutinise each investment product to understand if the product is really investing in ESG companies that fit the investor's ESG criteria. Just because an ETF has words "ESG" in its name does not necessarily mean that they will meet your ESG investment expectations.
Let me give you 2 examples of such funds.
The FlexShares STOXX® Global ESG Select Index Fund and SPDR® S&P 500® ESG ETF are both index funds that construct their portfolios based on their respective indexes, STOXX® Global ESG Select KPIs Index and S&P 500 ESG Index. Both indexes are designed to track companies that meet their ESG criteria.
Sounds legit right?
But for ESG-focused investors who have a strong preference for environmentally friendly companies may be shocked to learn that both funds contain top oil drillers, ExxonMobil and Chevron in their portfolio.
Likewise, just because your roboadvisor added an ESG fund into their portfolio doesn't mean the fund is good enough from an ESG perspective. Investors should that decision themselves by examining the fund to understand what its doing in terms of ESG.
As I was researching for this article, I also came across Stashaway's recent article that stated that, "ESG is the second best factor of investing, after quality", and also introduced both iShares ESG Aware MSCI USA ETF and iShares ESG Aware MSCI Emerging Markets ETF into their portfolio to "complement our existing portfolios, enhancing our sustainability scores while maintaining a strong focus on risk-adjusted returns."
After examining the portfolio of both ETFs, I felt the need to disclose that the iShares ESG Aware MSCI USA ETF portfolio consists of companies like Saudi Arabian Oil (also known as Saudi Aramco) which a Reuters article headlined the company as "an ESG investor’s worst nightmare" and that "Fund managers with any conscience should steer clear of Aramco. And if they don’t, their customers should consider boycotting them." Likewise, iShares ESG Aware MSCI Emerging Markets ETF holds companies like ExxonMobil in its portfolio.
I'm not going to say that these funds are outrightly greenwashing because the portfolio simply follows their respective investment objectives but it goes to show that ESG investing isn't as simple as picking 1 or 2 ESG-oriented funds out of the lot. At bare minimum, the investor will need to examine the fund's investment objectives, the investment methodology and the portfolio of companies that the fund holds.
ESG may not deliver above market returns
After going through a mountain of resources online, I found that there are mixed results as to whether ESG as a screening criteria played a role in helping investors delivering above market returns. In short, nothing conclusive.
An interesting study by Fidelity entitled, "Putting sustainability to the test: ESG outperformance amid volatility" concluded that in 2020, stocks at the top of their ESG rating scale outperformed those with weaker ratings in every month from January to September, apart from April when benchmarked against the MSCI All Country World Index.
However, the study also caveated that, "while each ESG grouping outperformed the one beneath it in the ratings, it is important to note that most rating groups underperformed the MSCI index due to the huge gains in the tech sector over the course of 2020." The study went further to state that, "Tech stocks are dispersed throughout our ESG ratings, from A to E, hence all five categories have not been able to keep up with the benchmark."
What does this all mean? I leave it up to you to make that decision after reading the study.
One thing I do agree is that companies with poor ESG ratings may contain some underlying legal or reputational risks that do not show up on the financials. Therefore it would be prudent for investors to include a negative screening in their investment criteria, that excludes companies that do not comply with their defined ESG rating.
Portfolio returns outweigh the need for ESG
As a small-time retail investor with a small investment portfolio, every dollar counts in the game of wealth accumulation.
I know it can be very selfish to say this but at least for now, wanting to grow my wealth to retire by the age of 50 strongly outweighs the aspirations of slowing down climate change, ensuring diversity and sustainability, and having companies improve their labour standards. I would argue that this is the reality for most retail investors who don't have a large net worth.
I would imagine that someone with a portfolio of $100,000 would be uncomfortable with investing 10% in ESG-focused funds that may result in lower returns because the lower returns from the $10,000 may be a big opportunity cost for the entire portfolio.
In contrast, I would think that someone with a portfolio of $1,000,000 would be more comfortable with investing 10% in ESG-focused funds with lower returns because $900,000 of the portfolio would easily cover the gap in returns while doing good for the planet and its people.
The above is simply my opinion and if you disagree with what I wrote, I'd love to hear your opinion in the comments section at the bottom of this article.
ESG is a good start but more needs to be done
With due respect, I do appreciate the people who are pushing for ESG investing and the ESG framework is sound. But I would like to see the ESG space mature further before I would be willing to put my capital into ESG investments.
ESG rating agencies will need to come together to agree on a standardised ESG rating methodology and data collection so that all the ESG rating scores have a tighter beta. This would make researching ESG investments a lot more efficient for retail investors like me.
This is a good to have, but I would really like someone to come up with a list of companies that are involved with greenwashing activities and allow investors to simply input the name or ticker of a ESG-oriented fund and fact check if the fund holds any stock of these companies. That would be really cool and help to improve the trustworthiness of ESG-oriented funds.
Are you a strong believer of ESG investing today or are you sitting on the fence like me?
Leave your thoughts in the comments section below and tell me what you think about ESG investing.