The Name Game
Call it what you will. Corporate Social Responsibility (CSR). Environmental Social Governance (ESG). Socially Responsible Investing (SRI).
This discussion and analysis will not dive into “the evolution of sustainable investing”, “sustainability and the corporate cost of capital”, or “sustainability and corporate financial performance” but on “Sustainability and Fund Performance”.
Meet The E, S, And G In ESG
The “E” includes everything from resource and energy management, waste and pollution, deforestation, carbon footprint, emissions reduction, and biodiversity impact.
The “S” covers health and safety, human rights, community relations, labor standards, supply chain monitoring, employee relations and diversity, and customer/supplier relations.
The “G” ranges from executive compensation to shareholders’ rights to Board diversity and structure to bribery and corruption to political lobbying and donations to tax strategy and code of ethics.
Responsible investing initially focused on eliminating (“negative screening”) controversial sectors—gambling, alcohol, cigarettes, and weapons—to meet the ethical guidelines of faith-based investors who opposed them. Over time the screens widened to exclude fossil fuels, nuclear energy, conflict zones, and oppressive regimes. As these funds began to appeal to both retail and institutional investors, the umbrella of responsible investing widened.
Currently, there is no one-size-fits-all definition of a responsible investing fund, nor is there an official body regulating the use of the term. If funds choose to use the designation, they must follow any guidelines they create for themselves in their prospectus documents. They make their own rules and can choose how strict they want their portfolios to be. There is an organization in the U.S. named US SIF: The Forum for Sustainable and Responsible Investment. As a membership organization, it promotes the objective of advancing sustainable investing using ESG criteria “to generate long-term competitive financial returns and positive social impact”. That being said, it has no regulatory powers.
View From The Street – Goldman Sachs on July 14, 2020
Is ESG investing sustainable? With goals that always seem to be in flux and links to performance that appear uncertain, the sustainability of ESG isn’t a given, despite massive public interest. Recently, GS Senior Advisor, Steve Strongin, shared his views on what will make ESG an enduring investment discipline. He says ESG managers need to identify companies and situations where ESG principles are creating real long-term advantages, as well as situations where doing good also means doing well in terms of corporate performance. He also talks about why anticipating ESG flash-points—things like the Black Lives Matter movement—is key to ESG’s success both as an investment and corporate strategy. “It’s [about] looking for companies that think about tomorrow’s problems—tomorrow’s flash-points—and operate today as though tomorrow’s values were already in place.
Behind The Curtains — Fund Construction
1. ESM Integration
While negative screening remains a popular approach, the most widely adapted strategy by far involves so-called “ESG integration.” Fund managers use ESG data alongside traditional metrics when valuing companies, especially in the long-term. Notably, integration does not rule out investing in any particular sector.
2. Positive Screening
Positive screening involves investing only in a sector’s best in-class names. Index providers such as MSCI rank companies based on their implementation of these principles and fund managers will build out a pool of the top stocks in each sector; In addition, companies like Morningstar assign sustainability ratings to funds and ETFs (exchange-traded funds). This method does not result in exclusions by sector. In Canada, for example, this leaves fund managers open to owning the top 20th to 50th percentile of oil and gas stocks.
3. Moral Suasion
There are some funds that buy the same securities that a non-responsible investing fund would, and say they’ll use their power as shareholders to pressure companies into adapting those principles.
4. Pure Play/Thematic
Another type of fund focuses on thematic investing and is made up entirely of clean technology companies or those with women in leadership. These funds are few and far between, however.
Behind The Fund Curtains — Greenwashing
Excluding the few pure clean tech and renewable energy-focused funds, ESG funds/ETFs often try to get that halo of responsible investing without being true to principle. ESG integration and the competitive desire not to fall behind “benchmarks” allows many “green-marginal-at-best” companies to reside within portfolios. In Canada, most of Desjardins ESG ETFs describe themselves as being “low CO2” but still contain names like Enbridge, Coal India, and Pembina Pipeline Corp. Other Canadian funds are loaded with similar names including Cenovus Energy as well as Exxon Mobil, BP, Royal Dutch, and British American Tobacco. US funds go dirty with significant positions in Big Oil, Big Coal, and fossil-fuel burning Big Utilities. Justification comes from “green snippets” in their business lines. “Oil producers like Chevron, Royal Dutch, and BP have invested billions into corn-based ethanol biofuels and hydrogen fuel cells. Utilities like NextEra Energy and Duke Energy are transitioning away from coal-fired plants and into solar and wind to constrain costs. ExxonMobil makes lubricants for wind turbines.” Less dirty is good, right? In the minds of most portfolio/fund managers, an unequivocal yes.
Behind The Fund Curtain — The Technology Stock Problem
ESG Index Funds are hot. That may be a risky thing for investors. Index funds that use an ESG stock-screening process are beating core S&P 500 funds this year. An overweight to one sector of the market helps explain the outperformance. Not only do investors need to weigh the risk of concentrated bets but ESG stocks may duplicate existing holdings. Outperformance and underperformance always need to be examined. And there are two likely reasons why a fund could outperform its benchmark. Either by overweighting the outperforming sector, or by lowering the expense ratio. In the case of the recent strong run, the answer is an overweight to the technology sector. The Vanguard ESG ETF has a 28% sector weighting to technology, which is significantly higher than the S&P 500 and iShares ESG fund’s roughly 20% weighting to the sector. It may be an advantage now but could be a bigger risk when things turn sour or, at least, experience mean reversion.
The ESG Technology Stock Problem — Bad Behavior
Alphabet (parent of Google) has faced worker walkouts for its handling of sexual misconduct claims against executives and just began a Board review. Apple’s new credit card was dinged with allegations of algorithmic gender discrimination. Amazon has been criticized for years over the direct reports to Jeff Bezos being almost exclusively white and male. On a very different matter and not really their direct fault but, according to an article from Energy Innovation & Technology LLC, technology companies across the globe likely consumed around 205 terawatt-hours (TWh) of electricity in 2018, or 1% of global electricity use. While this lies in stark contrast to earlier extrapolation-based estimates that showed rapidly-rising data center energy use over the past decade, it still amounts to major-league carbon pollution since 64.5% of the world’s electricity comes from fossil fuel-burning plants. Numerically, their share of carbon dioxide emissions amounted to 331,000,000 tons of CO2. That’s a lot of fizzy drinks.
Empirical Research — Committed But Few Are Following Through
As money flows into ESG funds, new evidence shows that most asset managers aren’t actually changing their investment behaviors. This observation is based on research published on March 20, 2020 by Soohun Kim and Aaron Yoon in their report, “Assessing Active Managers’ Commitment to ESG: Evidence from United Nations Principles for Responsible Investment (PRI)”. Among their findings: 1) funds typically enjoy a large influx of cash after publicly signing on to a prominent set of ESG investment principles, 2) publicly committing to the Principles led to no ESG score improvements (after six quarters) for the average investment portfolio, 3) the number of environmental controversies experienced by firms in the portfolios actually increased after they became signatories, while the number of social controversies decreased, 4) PRI signatory funds had lower ESG scores than non–signatory funds, 5) signatory funds voted less often on ESG issues after committing to the principles, 6) signatory fund returns actually fell after making a pledge, and 7) funds that tended to beat the market in the past did a better job of incorporating ESG into their portfolios after signing onto the Principles. Because there is no accountability for signatories, it appears some investment managers are reaping the benefits of an empty promise. What’s more, because there is a lack of an agreed-upon standard for companies to disclose and quantify their ESG performance, it is difficult even for well-intentioned investors to make responsible portfolio decisions and report their progress.
Empirical Research — Performance Metrics
The Early Years
In the early days of responsible investing, negative-screening (excluding sin and vice stocks) was all the rage. An extensive review and meta-analysis by Deutsche Bank in 2012 showed neutral results, though several small more specialized funds were able to capture a degree of outperformance. Importantly, they did not underperform. In fact, no academic studies found underperformance at either the security or fund level.
The ESG Integration Years
One study in 2019 by Wayne Winegarden of the Pacific Research Institute attempted to portray underperformance by ESG funds. The counter-argument focused on skewed capitalization selection and that the weighting to mid/small cap stocks and “pure” clean tech and renewable energy companies accounted for lower-than-benchmark returns. Large-Cap funds dominant the ESG universe and are uniformly used for return analysis.
A contention made by Morgan Stanley, that looks like a bit of cherry-picking, showed a review of sustainable mutual funds in existence for seven or more years had equal or higher median returns and equal or lower volatility than traditional funds for 64% of the periods examined. What sayeth 36%?
A more definitive study published by the IMF (International Monetary Fund) in October of 2019 in Sustainable Finance: Looking Farther came to this conclusion: There is no conclusive evidence in the literature that sustainable funds consistently out-or-underperform conventional funds. They did note, however, that restricted investment can reduce diversification benefits and limit investment opportunities, leading to underperformance. In the absence of clear evidence of underperformance of ESG funds, investors have justified allocation to the funds on the basis of similar fees between ESG and regular funds. Nonetheless, anecdotal evidence suggests that fees of sustainable active management funds are often higher than those of other active funds, posing a hurdle for wider adoption, especially by public pension funds. In sum, the research indicates that investors don’t necessarily need to sacrifice returns when they make investments in ESG portfolios.
The Trump Card — Labor Department Weighs In
HISTORY. The funds industry has said that sustainable investment funds and approaches are appropriate in public and private sector retirement plans. In 2015, the U.S. Labor Department affirmed that environmental, social, and governance issues can potentially influence risk and return of the investments in a plan. Therefore, the Department said, it is appropriate for fiduciaries to consider these issues in selecting or monitoring investments. The unspoken caveat was that investments in ESG screened companies should not negatively impact long-term returns or heighten volatility.
On June 23, 2020, the Labor Department announced a proposed rule that would keep retirement plans from increasing risk or decreasing returns in pursuit of “a social or political end. Others say existing law achieves that end.
According to the Department, the move “reminds plan providers that it is unlawful to sacrifice returns, or accept additional risk, through investments intended to promote a social or political end.”
Such investments have grown immensely in recent years, to roughly one of every four dollars under management. While little of that was in workplace retirement plans, some experts think 401(k) plans will play an increasing role in such investing.
A department spokeswoman said Democratic and Republican administrations had simply differed over the years in framing the obligations of employee plan administrators.
“Democrats say the standard is that it’s OK for you do to this as long as it comes out the same,” she said, referring to risk and returns. “Republicans say it’s illegal for you to do this unless it comes out the same.”
Jon Hale, the head of sustainability research at Morningstar, said the practical effect of the new framing could be to deter plan administrators from adding E.S.G. options to 401(k) plans for fear of violating the law. Even if the proposal does not come to pass, he said, employers might decide to avoid E.S.G. investments because they see them as a potential political minefield.
Nonetheless, this proposed rule only affects retirement plans so most of the ESG world can pretty much continue as it has.
Conclusion — Green Curious Not Green Pure
With the exception of a very few offerings in equity and fixed-income space, what you see branded is not what you actually get.
Probably the best way to say it is that “there is always going to be some degree of necessary compromises made when it comes to investing based on one’s ethics”.
What we know for certain is that like all investment strategies, no one approach equals or outperforms forever, and when strategies do work, it’s as likely to be because of the external market environment as a fund’s unique objective.
Feeling good about how you’re investing is a legitimate starting point, but it’s not an end unto itself.