Are ESG funds doing their homework?

This week, I want to comment on a question we frequently hear from publicly listed companies, using a recent academic paper that provides some interesting insights.  Are ESG investors truly doing their ESG homework on the stocks they are investing in?

Companies sometimes get frustrated that funds that label themselves as ESG investors are not always looking at ESG factors in depth. So, companies that are doing great sustainability linked initiatives can be overlooked for companies that probably are just better ranked because of the sector they belong to (hint: tech stocks), or because they are voluntarily disclosing many more metrics that improve their performance in some ESG ratings. Thus, the philosophical question is whether by just using ESG ratings as a screening tool are ESG funds doing enough to brand themselves as responsible investors.

Trying to answer these concerns with evidence, we want to share some highlights from a recently published paper from professors at LSE and CBS titled: “Do ESG Funds Make Stakeholder-Friendly Investments?” In it, the authors analyze a sample of 147 self-labelled ESG mutual funds in the US from 2010 to 2018, relative to 2,428 non-ESG funds managed by the same financial institutions in the same years. They look at their holdings and how these perform in different “stakeholder-related behavior” metrics. Here are some of their key findings:

• “ESG funds’ portfolio firms have significantly more violations of labor and environmental laws and pay more in fines for these violations, relative to non-ESG funds issued by the same financial institutions in the same year.”
• “ESG funds’ portfolio firms, on average, exhibit worse performance with respect to carbon emissions, in terms of both raw emissions output and emissions intensity.”
• “ESG funds are more likely to pick stocks that voluntarily disclose emissions.”
• “Our results suggest that ESG funds may rely on ESG scores rather than performing their own due diligence about firms’ environmental and social practices.”
• “…scores are only correlated with metrics that capture news coverage and the existence and quantity of voluntary disclosure (both with respect to carbon emissions and more generally), but not with the actual content of such disclosures.”
• “Relative to non-ESG funds, ESG funds’ portfolio firms have lower excess CEO compensation but also lower levels of board independence. The governance characteristics described are typical of high-technology firms.”

Obviously not all ESG investors behave the same way, and there are some who are truly dedicated to integrating ESG factors into their investment processes. There are even investors who don’t have an ESG label and are integrating many ESG topics into their investment processes thoroughly. (For example, Capital Group has about 45 professionals dedicated to helping all fund managers integrate ESG into decision-making, but no ESG funds per se.) But it is also true that there may be many funds that to get the benefits in fund raising that an ESG label provides, may be doing the bare minimum with respect to ESG integration.

We believe that the same way that over time companies will find it harder to green wash as investors are becoming more experienced on these topics, investors will find it harder to position a fund as an ESG fund unless they truly are walking the walk. In Europe regulators are already asking investors to be more transparent on how much integration they are doing (through the SFDR), and in the US the SEC has also highlighted in bulletins they want to see that “firms claiming to be conducting ESG investing need to explain to investors what they mean by ESG, and they need to do what they say they are doing.” This increased transparency should have an impact on how funds invest and behave if they want to keep the benefits of being an ESG-labeled fund, and this would not be reflected in the study from the paper we cited since it covered data up to 2018.

ESG is still a work in progress on many fronts, from standard setting to data processing, many of us are constantly adapting to improve and optimize sustainable finance practices. I understand the frustration some companies may feel with this as they can be investing significant time and resources into valuable initiatives. Our view is that markets will get better at recognizing all of it with a bit more time, and it will pay off.

And for those investors who want to chat about how they can improve their responsible investment practices, please reach out. We would be delighted to talk.

I hope you found this interesting. As usual, if there is anything we can help you with, or if there is an ESG topic you would like to know more about, please let us know.

Best,

Marimar

CEO, Miranda ESG

P.S. We will be pausing the publication of this weekly blog for a few weeks as I am really close to having a new baby, and the team will be 100% focused on providing continuity to our clients’ projects. I look forward to writing them again soon!