ESG FUNDS DELIVER OUTSIZED RETURNS … TO ITS MANAGERS

A 2015 MSCI study looking at ESG (Environmental, Social, and Governance) investing strategies over an eight-year period found evidence of alpha – or excess returns. A February 2021 Morgan Stanley review of more than 3,000 U.S. funds confirmed that ESG funds outperformed their traditional peer funds by a median total return of 4.3 percentage points in 2020.

ESG asset managers pitched these studies as a win-win opportunity – no sacrifice is required for investing in responsible, sustainable assets.  Companies committed to addressing ESG issues were, in fact, higher-returning assets.

Demand soared.  Inflows to ESG funds have been almost double those of the rest of the stock universe.  According to the Global Sustainable Investment Alliance, one in three dollars invested globally is invested in ESG assets.  

However, to assess the value to investors and planetary impact of ESG investing we need to validate the claims that ESG assets delivers alpha as well as positive environmental and social impact.

Reports of alpha are suspect considering the uncertainty of what constitutes an ESG fund.  There is no common definition or legal framework for ESG assets. According to the Financial Times “ESG is in many ways a bank’s marketing dream, precisely because it is so loosely defined.”

Asset managers can construct portfolios branded as ESG in any way they like so long as companies in their portfolio are pursuing plans to reduce their impact on the environment, address social issues and improve governance.

In its January 21, 2021, SEC filing Blackrock states that its: “…. U.S. Carbon Transition Readiness ETF (the “Fund”) seeks long-term capital appreciation by investing in large- and mid-capitalization U.S. equity securities that may be better positioned to benefit from the transition to a low-carbon economy.”  However, the U.S. Carbon Transition Readiness ETF has very little to do with carbon, climate change, or ESG.  Its largest sector investments are in information technology (28 percent of the fund) and health care (13 percent of the fund).  The fund also holds positions in Exxon Mobil Corp. (accused of lying to Congress that it covered up its own research about oil’s contribution to the climate crisis), Chevron Corp., JPMorgan Chase & Co. (the largest bank financier of fossil fuels), and Dover Corp. (an industrial conglomerate that manufactures gasoline pumps). 

Whether investors can generate alpha from ESG factors is also complicated by the challenge of determining where the excess returns are coming from.  Like BlackRock’s U.S. Carbon Transition Readiness ETF other ESG funds also hold substantial holdings in IT companies.  IT companies, that as a sector outperform other sectors, represent the largest percentage of holdings in most ESG funds with impact and climate tech investments making up less than 1 percent of ESG investments. 

With the growth of ‘responsible investing’ in ESG certified assets, why do total carbon emissions keep growing? 

Current ESG ratings systems do not consider overall impact; instead, they reward relative performance.   Like traditional funds, ESG funds are ultimately measured against financial return benchmarks.  They are not measured on the impact they deliver. According to Tariq Fancy, former global chief investment officer for sustainable investing at BlackRock, “Yes, ESG is on asset owners’ checklists, but they do not really check beyond getting the stamp of approval from someone like PRI [Principles for Responsible Investment] and asking a few questions around non-binding promises to consider ESG.”  No mystery, then, why ESG investing, as currently practiced, doesn’t deliver the Environmental, Social, and Governance changes promised. 

According to Merryn Somerset Webb, editor in chief of MoneyWeek, “an ESG fund will mostly have much the same effect on the world in which we live as a well-run non-ESG fund.” 

ESG may or may not be a source of outsize returns for investors or planetary impacting changes, but asset managers are winning by managing these funds. According to data from FactSet, the fees for ETFs defined as socially responsible investments are 43 percent higher than the fees for standard ETFs. The Wall Street Journal  wrote that this may be one reason “asset managers are among the biggest cheerleaders for sustainable investing.”