As clients clamor for investments dubbed socially responsible, regulators are closing in on how the widely used environmental, social and governance (ESG) moniker is bestowed and deployed.
It’s an urgent challenge. This year, the SEC cautioned companies and funds that tout their ESG practices and labels. As the wealth management industry talks up the benefits of socially conscious and values based investing, it may be putting financial advisors in a bind. Brokers may be pushing funds whose virtuous credentials are little more than feel-good promotions. Independent advisors can face pressure from clients for investments that might not be as good for their retirement portfolios as, say, an emerging market or real estate fund.
For individual investors who’ve gone all in, the regulation of sustainable investing could create a host of negative knock-on effects on their wealth accumulation strategies. Accounting firms that certify a publicly traded company’s financial results might find profits falsely attributed to their efforts to combat climate change. Lawyers might get exercised by broken environmental pledges to shareholders. High-profile campaigns to combat global warming, like Bill Gates’ Breakthrough Energy initiative, which has roped in $1 billion from companies working to reduce the costs of “clean” technologies, could find the entities they support not squeaky-clean under future standards. The law of unintended consequences would likely come down on any action the SEC takes to regulate investments in this area.
A welter of definitions and benchmarks pervades ESG investments.
jplenio for Pixabay
For financial advisors, much boils down to how the SEC will decide what kind of clothes the ESG emperor is wearing. Meanwhile, with no standardized system for assessing sustainable investments, how can people who are pouring money into them know what they’re getting?
“Which data and criteria are asset managers using to ensure they’re meeting investors’ targets — the people to whom they’ve marketed themselves as ‘green’ or ‘sustainable’?” SEC Chairman Gary Gensler asked the regulator’s asset management advisory committee on July 7. “I think investors should be able to drill down to see what’s under the hood of these funds.” He said July 28 that he wants the regulator to propose a mandatory climate risk disclosure rule for publicly traded companies and funds by the end of this year.
Virtuous investing means a lot of things If benchmarks are all over the map, so are the inconsistent factors they aim to measure.
“There are a growing number of people who want to feel like they’re investing alongside their values,” said Jon Snare, a managing partner at Bordeaux Wealth Advisors in Bellevue, Washington. “The problem is, ESG’s a fairly nebulous term. What does ESG even mean?”
ESG investing, sometimes also called impact investing, covers one corner of the socially responsible investing, or SRI, universe. Also sometimes called corporate social responsibility (CSR), SRI also includes diversity, equity and inclusion, or DEI, considerations.
Got all those acronyms? Collectively, the feel-good/do-good terminology refers to a host of broadly related things, including a company’s or fund’s carbon footprint, use or manufacture of fossil fuels, fair trade, “sustainability” (less packaging, water and deforestation) and animal welfare (how are those down feathers in your Canada Goose parka obtained?). And humanitarian matters (is the cotton in your jeans picked by forced labor in China’s Xinjiang region?) and conflict minerals and diamonds mined in regions to fuel fighting. And diversity (is that C Suite full of white men?), fair wages, executive pay, corporate board independence, anti-corruption and corporate political activity.
ESG indexes have become a cottage industry. In May, Morningstar launched an “ESG Risk Assessment” ratings system for investors to measure the extent to which a company’s enterprise value could be at risk if it doesn’t get on board the sustainable investing train. But the welter of benchmarks gauging the jumble of issues gets even more obfuscatory when it comes to how they’re calculated. A June article by the magazine strategy + business, which is published by accounting firm PwC, said that “there is no transparency in how rating organizations compile ESG scores, making it harder for investors to compare ESG scores or understand how they are calculated.” With ratings providers each using proprietary methods and companies self-reporting their data, the article called the mishmash of benchmarks “a Pandora’s box of variables.”
Tariq Fancy, the former chief investor officer for sustainable investing at giant asset manager BlackRock," argued that "zn industry is being built to deliver a placebo." The public, he said, "tends to believe there’s some impact out of these things, but by the additionality test” — a fancy word for value creation — “maybe 1% of funds have impact. 99% don’t.” He added that investments poised to actually make a positive change were mostly private, venture capital-backed startups developing clean air technologies, not widely available mutual funds.
Tariq Fancy, BlackRock's former chief investment officer for sustainable investing, at home in Toronto.
Bloomberg News
Green is the color of money Confusion aside, sustainable funds are fueling the early 21st century’s biggest investing trend.
One in every three dollars managed by U.S. money managers for institutional and retail investors, or $17.1 trillion out of $51.4 trillion, are now in “sustainable” assets, according to The Forum for Sustainable and Responsible Investment, a nonprofit.
Sustainable funds, defined as mutual funds and exchange-traded funds invested in stocks and bonds from companies seen as socially responsible, drew more than $56 billion (net) in the first three months of 2021, a record that surpasses all of 2020’s $51 billion, according to Morningstar. The 2020 level was more than double that of 2019, and nearly 10 times more than in 2018, the ratings agency said. Maybe money can grow on trees — or by associating with them.
EVestment, a unit of Nasdaq, lists 1,360 investment funds with dedicated ESG strategies, with 213 of them added in 2020 by 123 managers across 21 countries. The funds are run by managers of equity, fixed-income and alternative investment funds, as well as by real estate firms and hedge funds.
During the COVID pandemic, the allure of the corporate slogan “doing well by doing good” — making money while conducting business virtuously — gained force. “Social responsibility and sustainable profit go hand in hand, now more than ever,” wrote three McKinsey partners in the Milken Review last April. Which means Gensler’s “look under the hood” might split the ESG universe into winners and losers. Once the SEC formulates disclosure requirements, Fancy said, “you’re going to see tons of assets disappear from being sustainable.”
Wild West of ESG The ESG frenzy got a further boost from the recent climate summit in Glasgow known as COP26. World leaders (but not from China or Russia, two of the world’s leading greenhouse gas emitters) spoke of their pledges and commitments for a “Net Zero” and “Global Net Zero” world by 2050, in which the amount of gases going emitted is zeroed out by a like amount removed.
The European Union is further along in cracking down on investments that tout themselves as environmentally friendly but actually aren’t. Last March, E.U. regulators began requiring all asset management and fund companies, including U.S. ones, that market their investments in the E.U. to disclose climate, diversity and governance data.
With the U.S. lagging on the regulatory curve, there’s a lot for Gensler to police.
The SEC, which prohibits misleading advertising, hasn’t yet required companies and funds to disclose ESG data, but it’s rapidly heading down that road. In a shot across the bow, the regulator warned in a risk alert last April that “the rapid growth in demand, increasing number of ESG products and services, and lack of standardized and precise ESG definitions, present certain risks” that “can create confusion among investors.” On Sept. 22, it reminded companies that it is selectively reviewing SEC filings for climate-related disclosures. The regulator provided a template of the type of SEC letter that companies could expect to receive regarding their climate-related disclosures — or lack thereof.
The Biden administration is also weighing in. In an executive order issued last May, President Joe Biden signaled that he wants to rein in “greenwashing” by funds that trumpet their do-good credentials in combating climate change but that don’t back things up in disclosures to investors. The order cited the need for “consistent, clear, intelligible, comparable and accurate disclosure of climate-related risk by companies” — a job that falls to Gensler’s SEC.
Profits? Or ‘moral dividend’? For investors, one of the biggest questions is whether ESG investments can make good money. Or does it not matter, because some investors are willing to sacrifice some profits for a ‘moral dividend’? What’s clear is that data on the performance of stocks and funds marketed as ESG investments varies widely.
A widely read study earlier this year by NYU’s Stern Center for Sustainable Business and Rockefeller Asset Management found that companies and funds with an ESG focus had higher returns compared to those that didn’t. Companies that talk about sustainable practices but don’t follow through don’t see improved performance, while those with a strategy do, it said. The study based its conclusions on more than 1,000 research papers published between 2015 and 2020. A July 19 report by Fidelity International found that companies deemed ESG “leaders” are “more likely to offer attractive levels of long-term dividend growth across a range of economic scenarios.” Morningstar wrote in an Aug. 11 note that stocks with “low ESG-risk” typically perform “slightly better in weak markets or during a crisis” but sometimes underperform in strong markets.
The Journal of Banking & Finance reported last January that the higher a company’s ESG “profile,” the higher the company’s valuation. ESG, it found, expands a company’s existing overvaluation and reduces an undervalued company’s undervaluation. “CSR is indeed perceived as valuable by shareholders,” the study said.
But other studies suggest a disconnect between value as perceived by markets and investors and higher investment returns. A November 2020 study by the Journal of Portfolio Management said that ESG ratings for portfolios and indices screened for their ESG credentials are, when used in isolation, “unlikely to make a material contribution to portfolio returns.” A study last April by consulting firm McKinsey found that fewer than one in four companies makes money from its sustainability practices. Five years from now, only two in five companies expect to generate business “value” from sustainability. The McKinsey study’s definition of value is as ambiguous as the word “sustainable” and includes a company’s work with customers and suppliers with “sustainability factors.”
Sustainability means many different things when it comes to socially responsible investing.
Pixabay
One recent paper trashes the profit potential of ESG. “Honey, I Shrunk the ESG Alpha,” an April study by researchers at Scientific Beta, a data provider that’s majority owned by the Singapore Exchange, said that “there is no solid evidence supporting recent claims that ESG strategies generate outperformance.”
Rick Van Kuren, a senior partner and senior institutional advisor at LVW Advisors, an independent wealth management firm in Pittsford, NY, lamented that “there is no one statistic you can rely on,” including, he said, Morningstar’s ESG rankings of funds.
Coming for your retirement plan Last month, The Forum for Sustainable Investment, whose members touch $5 trillion in clients assets, released an updated “roadmap” for financial advisors on how to offer sustainable investments to clients.
But some independent advisors — who have a fiduciary duty, the gold standard to put a client’s best financial interest first — caution that virtuous investing may not boost overall returns.
“Excluding companies with large fossil fuel footprints will skew your portfolio toward, say, technology, and that has perils,” Van Kuren said. “You can find yourself unwittingly underperforming.”
The ESG love campaign by investment funds and asset managers comes as a marketing onslaught for all things climate friendly and socially just ramps up. Amazon.com has a bespoke “Climate Pledge Friendly” label for products it sells with less packaging, water and weight. Technology companies, like Accern, have launched AI-driven software for financial firms that parses news reports and alternative data “to capture ESG signals and create ESG scores” for companies. Next month, Columbia Business School will offer an online executive education course in ESG Investing (price: $2,150).
“COVID-Induced FOMO in Young Investors” said Chadwick Martin Bailey, a market research company in Boston, in an undated post on its website. “Don’t miss out on the young investor.” A Nov. 9 article from U.S. News & World Report is titled “Best Green Stocks Buy Now — it’s not too late to get in.” Merrill Lynch advisors use an “A-B-C” template that lets an investor choose stocks and funds based on whether they avoid certain industries, like fossil fuels, “benefit“ sustainable practices and/or contribute to “positive, measurable social or environmental outcomes.”
A Financial Planning survey of advisors in November found that 14% of clients were asking for ESG investments, with most interested in diversity. “They have no specific area and just throw out the buzzwords (climate change, social justice, income inequality),” one advisor wrote, adding that those clients were typically aged between 30 and 40, white and liberal. Penned another advisor: “I have clients who own Tesla, but it is for the car, not ESG.”
Questions from clients are likely to increase. On Oct. 14, the Labor Department proposed a new rule that would make it easier for retirement plans to offer ESG funds in 401(k)s.
Fancy, whose critical analyses last August of the green trend went viral in financial circles, called the proliferation of data providers, funds and consultants “the ESG industrial complex.” Individual investors, he added, are likely to pay the price, as funds charge higher fees “for the privilege of backing something green or nice.” The worst part, he added: “Even if funds and products are labeled correctly, the bigger problem I worry about is that the products have no actual real world impact.”
