Overview:
An article published by Bloomberg (2022) states that one in three dollars managed globally in 2021 was invested in ESG-related assets and that the total ESG investment market has accumulated more than $4 trillion since inception (Kishan, 2022). ESG stands for Environmental, Social, and Governance factors. Data from Morningstar showed a record inflow of $69 billion of new money invested in ESG investment strategies via mutual funds and ETFs in 2021 which was up from $51bn in 2020. It is clear that investors are using ESG strategies in their portfolios and that demand for such is on the climb.
However, many believe that the ESG investing approach is fundamentally flawed due to its subjective and arbitrary nature. ESG criteria can be overly broad, and the interpretation of these criteria can be extremely subjective. This leaves room for ‘greenwashing’, where companies appear more sustainable or socially responsible than they truly are. The lack of a standard framework for evaluating ESG performance further complicates matters such as what happened with Tesla.
In May 2022, Tesla was removed from the S&P ESG Index. Reasons cited included a lack of a low-carbon strategy, racial discrimination, poor working conditions, and Tesla’s handling of an investigation related to their autopilot vehicles that resulted in injuries and even death and whilst Tesla’s mission statement is to “accelerate the world’s transition to sustainable energy”, it would seem that they paid little attention to the social and governance factors of ESG scoring. However, a year on from the controversial decision, Tesla has been added back to the S&P ESG index off the back of Tesla providing information about ESG considerations in its supply chain management strategy and its assessment of physical climate risks. Risks that are material for a company in the automobile industry.
Unique or Superior
The assertion that ESG-specific funds consistently outperform the general market is debatable. Some experts argue that ESG strategies should be valued for the unique benefits that they provide to the environment or society, rather than being promoted for any potential outperformance because of a strong ESG score. Therefore, ESG investing should be seen as more of a soft benefit that provides investors with more confidence in the company’s ethics surrounding their operations and governance rather than a financial factor that provides superior performance.
Given the large inflows into ESG-related investment strategies, it is entirely possible that a company having an ESG classification could result in receiving more capital and therefore greater potential to expand than a competitor not having an ESG classification. However, if a company can produce the same level of profitability with its ESG policies as without them, then the return on investment should be fundamentally greater for the company as they would have achieved a greater risk-adjusted return. That is if you subscribe to the notion of the risk-return trade-off that suggests taking greater risk within your investment will generate greater returns.
The wider market indexes like S&P 500 and MSCI ACWI represent a diversified set of industries and sectors, which reduces the risk of significant negative impacts due to sector-specific events or trends. ESG funds, on the other hand, tend to be less diversified and may have a higher concentration in specific industries, which can lead to increased risk. Any outperformance in the long term would be more likely to be because of slightly higher volatility due to a lack of diversification rather than the underlying company deriving any financial performance because of actions taken to increase an ESG rating.
Summary
Larry Fink’s (CEO of BlackRock) recent announcement of ceasing to use the ESG acronym is significant given BlackRock’s previous strong advocacy for ESG investing. His assertion that ESG has been “totally weaponized” and “misused” highlights the politicization of the approach and how ESG can be misunderstood by investors. While ESG alignment can be seen as a positive feature in a company’s operational ethics, it shouldn’t be the only factor in evaluating an investment’s potential return. It’s not always the case that a company’s alignment with ESG values will translate into better financial performance. A focus on ESG factors can potentially divert resources from profit-maximizing activities, and this could impact a firm’s competitiveness in the long run.
At its core, ESG investing should be viewed as a risk-mitigation and diversification tool and not included in your portfolio to solely improve profitability/return on your investment. It is critical to note that investors should not be guided by popularity or any one single factor but rather through a thorough assessment of the company.