Is ESG just hype?
Investors reassess sustainability investments amid weak performance
The idea of doing well and doing good through investments based on environmental, social and governance or ESG factors has attracted billions of dollars into these opportunities over the past decade.
According to Morningstar, global sustainable fund assets reached US$2.8 trillion as of June this year, accounting for 7% of global investment assets, up from 4% five years ago. These are funds labelled as focused on sustainability, impact investing, or ESG factors based on their prospectus or regulatory filings.
Europe dominates the sustainable fund market with an 84% share, followed by the US with 11%. The third largest is Asia ex-Japan, led by China with more than 72% of the region’s asset base.
However, the growth is slowing down in many regions, declining from the global historic peak of $3 trillion recorded at the end of 2021.
Last year, total ESG fund assets declined 29%, sharper than the 21% decrease in non-ESG assets. This has continued into 2023, with net flows into ESG assets plunging more than 40% to $18 billion at the end of the second quarter from $31 billion in the first three months of the year. While there was a $20 billion net influx in Europe, outflows were recorded in the US, Australia and New Zealand, and Japan, amounting to $600 million, $1.7 billion, and $1.9 billion, respectively.
ESG equity funds also underperformed traditional funds last year for the first time since 2018, with the value dropping 19% compared with a 15.7% decline in traditional funds. This too has persisted into 2023. Despite the tailwind provided by a rally in big-name technology stocks which score high on ESG criteria, sustainable investing indexes lagged behind the broader market’s rally.
Morgan Stanley notes in a report in February that much of this underperformance was driven by market factors. Amid recession fears, inflation and the Russia-Ukraine war, equity markets rotated towards value over growth, while in the fixed income market, shorter-dated bonds outperformed. These impacted sustainable funds considerably due to their more growth-oriented focus on long-term opportunities.
Nevertheless, Morgan Stanley points out that “despite short-term fluctuations, investors with long-term horizons appear to be holding steady with patient capital in sustainable funds”.
Higher valuations, lower returns?
So how patient should investors be in holding onto sustainable assets to reap rewards?
Bankeronwheels.com, a UK-based investing website, argues in a June article that “investors have developed a taste for sustainability that inflated valuations. This taste is the very reason why ESG ETFs are poised to underperform on a risk-adjusted basis. More flows mean higher valuations today and lower expected returns tomorrow”.
“Sustainable investing is like a luxury good. Flows tend to be higher in good times and lower in recessions because investors cannot always afford it,” it adds.
Several academic studies have cast doubt on the correlation between ESG factors and fund performance.
For instance, University of Chicago researchers analysed the Morningstar sustainability ratings of more than 20,000 mutual funds representing over $8 trillion of investor savings. Their findings, published in the Journal of Finance in December 2019 revealed that although the highest-rated sustainability funds attracted more capital than the lowest-rated ones, none of the high-rated ones outperformed their low-rated rivals.
Meanwhile, researchers at Columbia University and the London School of Economics compared the ESG records of US companies in 147 ESG fund portfolios and those in 2,428 non-ESG portfolios from 2010 to 2018. The report, published in the Review of Accounting Studies in May 2022, found that companies in the ESG portfolios had worse compliance record for both labour and environmental rules. Additionally, companies added to ESG portfolios did not subsequently improve compliance with labour or environmental regulations.
Another study by the European Corporate Governance Institute in November 2020 compared the ESG scores of companies invested in by 684 US institutional investors who were signatories to the United Nations-backed Principles of Responsible Investment and 6,481 non-signatories between 2013 and 2017. It found no evidence of improved ESG scores for companies held by funds after they became signatories. Furthermore, the financial returns were lower and the risk higher for the signatories.
On the other hand, a comprehensive meta-study by the NYU Stern Centre for Sustainable Business in collaboration with Rockefeller Asset Management which analysed more than 1,000 research articles published between 2015-2020 showed that 58% of those papers found a positive link between ESG and investment performance. Only 8% showed a negative relationship, while 34% were neutral or mixed.
Complex and conflicting
It’s too early to draw any definite conclusions from these studies. Examining the link between ESG factors and investment performance is complex.
For one, a standardised framework for ESG assessments is lacking due to variation in data sources, differing methodologies, and subjective judgement. A study by The Wall Street Journal in May 2021 analysed the ESG grades of nearly 1,500 companies from Refinitiv Holdings Ltd., MSCI Inc. and Sustainalytics and found that nearly two-thirds were rated differently by the firms.
Furthermore, almost one-third of the companies were named an ESG leader by one or more ratings firms but considered an ESG laggard by at least one of the other firms.
Another issue is that inconsistency in ESG ratings can lead to significantly different holdings by indices and funds. For example, in May 2022, Tesla was removed from S&P 500 ESG Index and ETF due to workplace and governance issues. The electric car maker also ranked 21st on the Toxic 100 Air Polluters Index compiled annually by the U-Mass Amherst Political Economy Research Institute. Tesla Chief Executive Officer Elon Musk was outraged with the assessments. “ESG is a scam. It has been weaponised by phony social justice warriors,” he declared.
Nevertheless, Tesla is still held in the two largest ESG ETFs. It was the sixth-largest holding in the iShares ESG Aware MSCI USA ETF and the seventh largest in the Vanguard ESG U.S. Stock ETF at the time of writing this article.
Some argue that the surge in ESG investments has been driven by investors aiming to make a positive impact on society by forcing companies to change, and hence their performance should be evaluated on the impact they have made rather than solely on relative returns.
It’s true that integrating ESG in investment decisions has led to positive changes in corporate behaviour and sustainability practices. However, the increasing scrutiny on ESG investment performance indicates that investors also care about the bottom line. They want to “do well and do good”.
The problem is, the “do well” part is not adding up as expected. This concern is evident in Schroders’ 2022 institutional investor study, which found that over half the investors were concerned that ESG performance was hindering their sustainable investing decisions.
A company may excel on the environmental or E front, but score poorly on the governance or G aspect. Therefore, investors will have to weigh the trade-offs against their own investing priorities.
Traditional investing focuses on making an objective assessment around risk and opportunities, but ESG adds a more subjective layer related to values and ethics. This makes the decision-making process much more challenging. The trade-offs on multiple factors may be conflicting and difficult to assess and compare.
New York University finance professor Aswath Damodaran has pointed out multiple times that narratives around ESG have evolved over the past decade from “doing good” to a source of alpha generation, then to risk metrics, and now as a measure of disclosure. It has become a broad catch-all concept which he thinks should be retired.
It’s time to refocus ESG investing on its basics and demystify the hype. Investors should be better educated to understand what their ESG portfolios are exposed to, and gain a clearer understanding of the trade-offs. Industry and regulatory bodies have a lot more work to do in this regard.
*This article was published in Asia Asset Management’s October 2023 magazine under the same title.
