ESG investing faces sustainability test

Along with support from politicians and younger investors, such broad interest from fund houses should ensure further growth. But the sector’s success could create new problems. We offer a guide through the ethical maze.

Is ESG just a marketing label?

Not judging by its size. The ranks of investors who say they pay attention to factors other than pure profitability are growing rapidly. Managers of stocks, bonds and other assets worth some US$83 trillion have signed up to the Principles for Responsible Investment, an initiative backed by the United Nations that promotes the inclusion of ESG factors in asset allocation.

It is hard to know how many of those funds truly build ESG factors into their investment choices, however. For some, signing up is just a box-ticking exercise. Still, research group Morningstar reckons that what it calls “socially conscious” funds — which invest according to non-economic guidelines — managed US$1.2 trillion at end-2018. Fans include BlackRock boss Larry Fink and Deutsche Bank’s DWS fund arm.

Isn’t this just old-style ethical investing under a new banner?

There is some overlap. Ethical investing means avoiding companies that violate an investor’s moral code. So, religious funds might steer clear of groups involved in birth-control products or pornography. These ethical concerns fall under the social part of ESG. Investors can extend the same approach to the environmental or governance part by, say, shunning companies involved in fossil fuels or those with poor shareholder rights.

But the core principles of ESG investing are about more than weeding out wrongdoers. Investors try to assess the risks and opportunities presented by ESG considerations. That is why it is often called sustainable investing.

How did it get so big?

Lots of reasons. The near-collapse of the Western banking system in 2008 woke investors up to the dangers of prioritising short-term profitability. The increasingly apparent threat from climate change has played a big role, too. Proponents also point to demographic trends, such as the emergence of the more socially conscious millennial generation, or retiring baby boomers, who once marched for peace and can now afford to fund their earlier crusades.

Asset managers have talked up the sector to appeal to these clients. It helps them demonstrate ways of creating value at a time when investors are defecting to low-cost passive funds. Government support could provide a further boost. The European Commission is actively trying to channel more capital into sustainable funds by incorporating ESG principles into key regulations and forcing fund managers to show how they integrate them into investment processes.

In the US, President Donald Trump’s scepticism about climate change means there is no federal support. Indeed, the Department of Labor last year said fiduciaries should “not too readily treat ESG factors as economically relevant”.

Are all these investors really doing ESG analysis?

It’s hard to say. Some fund managers do little more than screen out particular industries. Some slavishly follow indices, based on scores provided by specialist rating firms. Others will analyse ESG factors in detail and take companies to task on them. Some may simply be paying lip service to the trend to attract clients.

The bigger challenge may be that the sector is actually trying to do too much. Analysing ESG factors involves a fair degree of subjectivity. It is possible to measure a company’s carbon footprint, but much harder to assess its social impact or business ethics. It is also hard to bundle such different and complex issues together, or work out which is the most important.

The growth of ESG scoring has been particularly crucial, as it has made it easier to create portfolios that can appeal to a broader range of investors, and construct index products. ESG scorers typically grade companies according to individual criteria — such as their treatment of employees or impact on the environment — and bundle these into a single score. Companies are sometimes graded relative to peers, rather than on an absolute basis.

The outputs are debatable. The Dow Jones Sustainability Europe Index includes cigarette purveyor British American Tobacco, while oil giant Royal Dutch Shell features in Vanguard’s SRI European Stock fund. Facebook appears in several indices even though Mark Zuckerberg’s company gives its shareholders limited voting rights and has been plagued by ­data-privacy issues.

Will investing along these guidelines cost me money?

Not so far. Supporters argue that ESG investing should outperform over the long term because it avoids companies whose earnings are flattered by unsustainable habits, such as relying on child labour. That may be true, but getting the timing right is tricky. Customers and regulators can tolerate supposedly unsustainable business practices for years. And even if ESG funds should outperform eventually, in the short term they will be hampered by having fewer assets from which to choose.

However, the ESG industry seems to be winning the argument. The MSCI World ESG Leaders Index has performed in line with the MSCI World Index since its inception in 2007. Sustainable funds did better than ordinary ones during last year’s rout, Morningstar reckons.

So, time to set up an ESG fund then?

Not so fast. There is a danger that ESG investing becomes a victim of its own success. It has not been through a proper investment cycle in its current size. As the sector grows, it will influence prices, as various funds and index products crowd into the same companies. That could create arbitrage opportunities for non-ESG investors. And if the sector has a bad spell, investors may prove just as fickle as less ethically motivated ones.

Data is another issue. As sustainable investing has grown in importance, companies have published information designed to flaunt their virtues. There is a risk that ESG scores are manipulated or diluted. It does not help that there is no obligation on companies to provide intelligible or standardised reports — though lobby groups are encouraging better disclosure.

Despite the challenges, support from regulators and politicians means that ESG funds are probably here to stay. If that means that investors spend more time thinking about longer-term risks and less about quarterly results, it may be no bad thing.