Log inThe ESG Myth from Jilly Mann
ESG is the current buzzword of investing. It is nigh on impossible to read any article or listen to any fund manager presentation without ESG being shoehorned in somehow. ESG represents Environmental, Social and Governance factors when applied to an investment portfolio. With the ever-increasing focus on slowing down climate change and moving to a greener society, ESG should be a noble aim, but unfortunately it is fast becoming a mockery of what was intended for it.
To put this into context, we have been running ethical investment strategies since 2011, these strategies comprise of funds which are rated somewhere on a “various shades of green” scale; so dark green represents funds with very strict ethical parameters and negative screening (i.e. the absolute rejection of any stock which fell within outlawed sectors irrespective of performance); whereas lighter green represents those funds which reject certain headline sectors such as tobacco outright, but who perhaps choose to engage with sectors such as biotech to find alternative solutions than animal testing for example. This method of screening has always been available. Admittedly over the last five years, there have been fewer launches of new ethically screened funds such as these and so there has been much less choice for investors, but nonetheless there are some exceptional ethical funds of all types, who have always taken ethical screening seriously and who have produced returns often in excess of their non-screened rivals.
It is possible to buy an index fund tracking the FTSE4Good index if low cost and less diversification satisfies an investor’s needs. That said, look at the top 10 holdings of such tracking funds and names such as Royal Dutch Shell, Rio Tinto, BHP appear regularly. These stocks are not natural bedfellows for those investors who are worried about climate change and environmental change.
We are now in an age though where the lines have become blurred. All fund houses are now under pressure to demonstrate the ESG behaviour of all their funds. Whereas active fund managers were previously quite differentiated between those who screened and those who didn’t, now the trend is for all funds to be seen to be pushing for positive change. This approach simply blurs the lines for those investors who have genuine ethical concerns.
For example, we can sit through fund manager presentations where ten minutes is devoted to a desperate attempt on their part to legitimise the ESG benefits of their fund. We will have to hear about all of their engagement with management that they do to try to make things better, to improve working conditions, improve end products and to improve the culture within these organisations so that every decision the company makes is based on ESG factors. We are shown company annual reports with the ESG section highlighted, but the reality is that neither we nor investors are so easily fooled. If within the top ten holdings of a fund are miners, tobacco companies, and arms companies then no amount of rhetoric will get away from the fact that these are not traditionally ethical holdings. When moving onto banks as an example, one enters a moral maze around who they lend to, how they lend and how they then put their own capital to work.
That is not to say that funds shouldn’t engage with these industries to improve them or their working methods, they absolutely should, but to pass these off as proof of the fund house’s ESG commitment is a fallacy. These stocks are owned primarily because, rightly or wrongly, they are some of the strongest performers within global stock markets. Over time, that will change and the more pressure companies are under to change, the quicker that will come, but that pressure will come from voices that genuinely care about these matters, not those more worried about remaining the number one fund in their sector.
These ESG pressures are also coming through in index investing. Gone are the days when you bought an index and you knew what was in it, so you could decide if that mirrored your own views. Now we are awash with new ESG index tracking funds, however, the indices being tracked are bespoke indices created by fund houses based on their own criteria. Some of these are focused on climate change, gender, ESG, clean energy, water. However, it seems that some of these supposedly ESG/socially responsible indices are remarkably similar to a standard FTSE100 tracker, two of the recently launched indices we looked at included, BAT, BHP, Rio Tinto, William Hill and Royal Dutch Shell.
The Morningstar fund ratings agency have recently also launched a Sustainability Rating for funds. This isn’t the first time Morningstar have launched new ways of rating funds and so the long-term success of this service remains to be seen, but it represents further pressure on funds to back up their ESG proclamations. This new rating service will at least force the fund manager’s hands, because the service ranks both funds and their underlying holdings and so it will be harder for fund managers to hide. Tesla is a good example of a stock which Morningstar have rated. The stock ranks well for the E (Environmental), but lags on S (Sustainability) and G (Governance). The intentions of the company with clean energy products are there for all to see, but their mode of achieving these products and managing the business are less impressive. Another stock where one could see clear differences between the success of E, S and G would be Amazon, one of the leading stocks in the world.
This article is not intended to denounce ESG, we run ethical portfolios for ethically minded investors and those who want to support ethical objectives where ethical investment options allow, the lack of ethical investment options in some major Western markets remains a bone of contention. Investors need to be given a clear picture of the true ESG credential of the funds they own. Few people would say they don’t care about the environment but caring about the environment and doing something about it rather than ticking a box hoping nobody questions it are two very different things. ESG investing must evolve and it will over the next ten years, but in the meantime, don’t just believe the hype, sustainable investing is about much more than just a label.