ESG investing is having a moment in the sun but there is a lot of work to be done

Institutional Sales & Distribution, Shyan Khleeli unpicks the complexities of ESG investing, especially as it transitions into the mainstream.

By Shyan Khaleeli, Institutional Sales & Distribution · October 21, 2020

Although 2020 has been a blockbuster year for ESG Investing, it has also highlighted that the sector is still in its infancy. As more players enter the market, there is a need for greater regulatory oversight and the institutionalisation of an enhanced end-to-end ESG framework. The rise of greenwashing underlines the importance of committed, active ESG investors in the evolution of this complex market.

“ESG fund flows accounted for almost one-third of all European fund sales and gathered 63% more new money than traditional equity funds in Q2 2020”

In July 2020, ESG products had just over $1tn of assets under management globally, with net inflows of $7.1bn between April & June. European ESG funds alone attracted inflows of €54.6bn in the second quarter of 2020, 110% up, from €26bn in the first quarter of 2020. In fact, ESG fund flows accounted for almost one-third of all European fund sales and gathered 63% more new money than traditional equity funds in Q2 2020. Passive funds are receiving a significant share of these inflows and this is expected to continue & accelerate driving passive funds to overtake active funds. Research by consultancy ETFGI showed that global assets in ESG classified ETFs & ETPs rose above $100bn in July 2020 with net inflows of $6.76bn in July. According to a recent survey of European institutional investors, pension funds, mutual funds & insurance companies currently allocate only 21% of their ESG exposures to passive funds. Around 50% of those surveyed, expect to increase their ESG exposure in ETFs over the next two years. This shift toward ESG has been supported by numerous studies highlighting the strong performance of ESG funds relatively to their traditional counterparts. Research from data provider Morningstar examining the long-term performance of a sample of 745 Europe-based sustainable funds shows that most strategies have done better than non-ESG funds over one, three, five and ten years. That said, there is still significant debate regarding the performance of ESG funds with a recent academic study finding that firms with a higher ESG score did not experience superior returns with the onset of COVID-19.

Alongside the growth of ESG Investing, ESG rating providers have become increasingly influential; with many investors relying on these ratings to obtain third party assessments of corporations’ ESG performance. That said, according to research conducted at MIT, ESG ratings of the same company by different ratings agencies, only line up with one another ~60% of the time. The MIT researchers also found that rating divergences are predominantly driven by the range of attributes ratings are based on and the measurement of these attributes using different indicators. For example, Tesla is rated in the bottom 10% of all companies by one rating agency while another gives it an “A” grade. This is because one agency places an emphasis on workers’ rights while the other is focused on the company’s environmental impact. The wholesale standardisation of ESG ratings is not desirable as a range of opinions from different experts can form useful data points in investors’ decision-making processes. Alternatively, it makes it difficult for investors to compare investments which are marketed as sustainable which in turn makes it less likely that ESG performance is reflected in corporate stock and bond prices. The divergence in ratings also sends mixed signals to companies trying to improve their ESG performance. Given the growing weight of ESG ratings, greater transparency with regards to rating methodologies coupled with more rigorous standards and oversight would reduce the risk of ESG ratings becoming a box-ticking exercise. Furthermore, as many active investors in the space note, ESG ratings should only be used as a guide not as gospel. Given the opacity in the market it is especially important that ESG investors conduct their own diligence and analysis and get creative with regards to collecting data to assess ESG performance.

“To improve the quality of data underpinning ESG ratings, accounting bodies must require a minimal level of standard, auditable, ESG performance data to be collected and reported.”

Underlying concerns related to ESG ratings is the need to establish confidence in the quality of companies’ ESG performance data. In July 2020, fast fashion retailer Boohoo faced fresh allegations of poor working conditions in its supply chain. A month earlier, ratings and index provider, MSCI had reiterated Boohoo’s double A rating and placed it amongst the top 15% of its peers based on ESG metrics in an update of Boohoo’s ESG ranking.  At the time, 20 sustainable investment funds were invested in Boohoo and asset managers who highlight their ESG credentials were among its 30 largest shareholders. Some question why ‘so-called’ sustainable funds would invest in fast fashion at all given that the low prices likely necessitate poor supply chain practices such as cheap labour. Regardless, fund managers and rating agencies often rely on data provided by companies themselves. Boohoo was not required to publish audited data on staff turnover, pay distribution or the use of agency workers. To improve the quality of data underpinning ESG ratings, accounting bodies must require a minimal level of standard, auditable, ESG performance data to be collected and reported. Companies may then opt-in to collect and report data and metrics over and above the minimum requirements. The increase in cost of collecting additional data will be discouraging for some but integrating ESG metrics into financial reporting will significantly reduce the risk of green-washing and provide a more holistic view of companies’ performance.

The picture is just as complex and nuanced when looking beyond companies and rating agencies to the make-up of ESG funds. Based on Morningstar data, in July, eight of the ten of best performing large-cap US ESG funds had either Apple, Amazon or Microsoft as their biggest holding. In fact, 17% of those fund’s portfolios were in Facebook, Amazon, Apple, Netflix, Alphabet or Microsoft. This has drawn criticism from campaigners such as Lauren Peacock at ShareAction who believes there is a risk, as in the case of oil and gas, that investors do not want to rock boat when returns are good. A number of these companies have been under the spotlight: Facebook has been criticised over weak data privacy & misinformation; while Apple and Amazon have been censured for poor working conditions in factories in China and other facilities. On the other hand, technology companies are some of the most focused on renewable energy and sustainability. For example, Google signed up to a $2bn renewable energy deal, while Microsoft committed to being carbon negative by 2030 and Apple has pledged to being carbon neutral for its products and supply chain. As a result, ESG investors must often take a holistic, forward-looking view and assess a company’s intentions as well as behaviours with regards to ESG goals. For example, on the face of it Tesla appears ESG compatible but issues may arise when analysing the full value chain. Another example is the reliance of manufacturing facilities on fossil fuels, especially in China, weak governance rules and mandatory arbitration policies. Nonetheless some ESG fund managers have invested in the business based on the weight of its environmental credentials and an openness to change. Given this complex balancing act, it is especially important that ESG investors actively engage with companies on their ESG performance. Stewardship can and is being used by a growing number of active investors to effect long term change.

It is clear ESG investing is making a welcome transition into the mainstream but as noted above this has shone a spotlight on the relative immaturity and inherent complexity of the market. As such, active ESG investors play an imperative role in leading ESG integration & stewardship and safeguarding the sustainable growth of the sector. Funds with impact at their centre and with accompanying metrics would do well to make their strategies clear to help the entire industry move forward.