Should you ESG invest? ESG funds are becoming popular but do ESG investment perform better? Whilst we may want to improve our planet most investors don’t want to risk their money. You might not want to invest in risky ventures and green companies that are burning through cash. Therefore, you might be wondering how you can invest in ESG and reap the benefits.
Ethical, Social Governance (ESG) creates social value by reducing funding for harmful companies. ESG investing is the practice of refining a fund down to the companies that meet strict criteria. This is often based around sustainability practices such as maintaining a low-carbon footprint. ESG offers strong potential returns for investors willing to hedging in favour of sustainability.
This is achieved by cutting out of companies, that shouldn’t have a place in our future. For example, Oil companies spent hundreds of millions blocking climate change action. These companies created misinformation around global warming. This has put the entire planet on the precipice of an extinction level event. So is it time to find a fund to ESG invest into?
The Problems With ESG Investing
According to Morningstar, there are currently 502 ESG/Sustainable different mutual funds and ETFs available in the US. This can highlight two things.
Greenwashing is a prevalent issue surrounding ESG. This makes it difficult to know if you should ESG invest.
There is growing variation in funds due consumer preference. All of them may differ in their own definition of ESG.
Green washing is becoming a major issue. You now see oil companies advertising green energy whilst their actions point to the opposite. ExxonMobil Chevron, Shell and BP have all been accused of greenwashing. What happens if they start investing enough dollars into green energy, whilst continuing to pollute the earth. Do they then become sustainable?
We should there be cautious in terms of both preference that we are selecting the appropriate ESG fund. For example, we may want to focus on carbon emission improvements to be more specific. Evidence here shows that this can accelerate returns and it’s also relatively straightforward to control for in an ESG fund.
The ESG Field Is Immature
The argument can be made that the ESG field is too immature. There is a lack of an agreed paradigm. As a result, greenwashing can take place. You then end up paying a premium to access someone else’s ethical standards. As a result you might find it difficult to genuinely ESG invest.
Where do you stand on Nuclear power for example? Many funds may believe they are ESG because they are focused on decarbonisation. As Nuclear power doesn’t generate carbon emissions this would be aligned with that goal. It does however generate nuclear waste and you might not be comfortable with that.
You might by contrast be fine with Nuclear power but your fund doesn’t tackle supply chain issues. This may include unsafe working conditions or unsustainable production of a resource. Therefore, it’s really up to you to decide where your ethical line is. We can’t assume all ESG funds focus on every area of ethical social governance.
Ethics Is A Relative Concept
Facebook (now META) are a common feature of ESG investment funds. This is despite accusations around a lack of governance around misinformation and fake news. You could also argue technology companies lack fully developed consumer protection laws (e.g. how they control your data).
In fairness, this is difficult to implement because technology is moving at such a fast pace. There may also be greater negative impact than we yet understand or can even comprehend. ESG funds might still be too underdeveloped to even appreciate a lack of data governance. This lack of governance makes it challenging to evaluate funds in order to ESG invest.
Disclaimer: This is not financial advice and you are responsible for your own investing decisions. When investing capital is at risk.
Andrew | Mr Money Side Up
ESG Funds Can Differ In Their Investment Strategy
Can ESG investments perform better? Perhaps not in the short-term but I would speculate that they can in the long-term. We know that companies investing in solar panels, wind turbines and fusion technology might underperform in the short-term. This is because cost-efficiency for new technology is lower. The investment required for R&D is also higher. Where as oil companies are already stable and profitable.
These variances can be seen in the variation between ESG fund strategies. Schroder’s highlight that in a 5 year period, the MSCI USA ESG Leaders index underperformed the MSCI USA, whereas the MSCI USA Climate Change index outperformed by 18%.
It is therefore important to understand that not all ESG funds are made equally. This makes it difficult to know if ESG investments can perform better. This is because ESG funds focus on different areas of sustainability. There may also be alterations in asset class, region and market cap which can influence returns.
Large-cap technology stocks may have driven strong returns for some ESG funds in recent years. Technology stocks which may be driving us towards an asset superbubble.
How Does ESG Create Value?
It has been widely debated if ESG investment can perform better than their non-esg counterparts. Investors used to have limited access to ESG funds. In many cases these funds charged a premium for investors to align their investments with their values. This has caused more problems for would-be ethical investors than the value ESG funds create.
The fees associated with ESG funds seem to be moving in the right direction. This is because there is a strong growing market of consumers that want to invest in sustainable companies that prioritise climate change and cut out unethical practices.
The result is that companies such as Blackrock want to make ESG a core feature of the investment process. This can result in powerful change: There is less money pumped into companies that pollute our environment and our society. Whilst companies which encourage positive change are funded with more of investors money.
This is where it becomes difficult for investors. How have ESG funds performed in comparison to non-ESG funds historically? More importantly, will this change in the future, as demand and need for sustainability becomes an increasingly pressing need.
Can ESG Investments Perform Better?
In 2015 there was a meta-analysis of over 2000 empirical studies on ESG performance. This study found roughly 90% of studies reported a nonnegative relation between ESG–CFP (corporate financial performance).
In fact, they note that the most studies report a positive relationships between ESG and CFP. Also that the positive ESG impact on CFP is stable over time. The study also identified ESG outperformance opportunities in many areas of the market. This includes North America, Emerging Markets, and in nonequity asset classes.
This aligns with Blackrock’s findings that focusing on ESG may pay the greatest dividends in emerging markets. At the very least there is no sacrifice required for moving towards ESG investing. Read the full report here.
According to Blackrock, sustainable investing has also been shown to be resilient amid uncertainty. In late February 2020, the Dow Jones Industrial average declined 34%, as the pandemic spread. By contrast, Morningstar reported that 51 out of 57 sustainable indices outperformed the broad market counterpart. At the same time the MSCI reported 15 of 17 of their sustainable indices outperformed broad market counterparts.
Blackrock observed that “better risk-adjusted performance across sustainable products globally, with 94 per cent of a globally-representative selection of widely-analysed sustainable indices outperforming their parent benchmarks”
This has lead them to conclude that “combining traditional investing with environmental, social, and governance-related (ESG) insights to improve long-term outcomes”…
“companies managed with a focus on sustainability should be better positioned versus their less sustainable peers to weather adverse conditions while still benefiting from positive market environments.”
Can ESG Investments Perform Better: ESG and The Bottom Line
ESG encourages to flow of money to companies focused on sustainability. This can be rewarding for both the company and the investor. Companies that reduce waste can be rewarded when it comes to their bottom line. According to the LA times:
Nike Inc. has come up with a way to weave more efficiently, reducing the raw material and labour time needed to make each shoe. That has kept more than 3.5 million pounds of waste from reaching landfills since 2012.
United Airlines Holdings Inc. has been making its planes lighter, driving down fuel use and costs. Airlines account for almost 2% global carbon emissions.
Google, Facebook and Amazon committed to using 100% of their energy from renewable resources, saving up to 10% of their utility bills.
I also remember reading that PG tips cut 3mm off the diameter of their tea bags, and this saved £3 million in the process. There isn’t a clear cost-benefit choice between sustainability or profit margin.
Can ESG Investments Perform Better: So What If They Don’t?
Every time I watch a documentary about nature, wildlife and climate change I am just so shocked and upset. It’s crazy what we are doing to the planet. It’s not just global warming but unstainable supply chains that destroy habitats. This ranges from deforestation in Borneo to plastic waste both in Maldives.
We’re often made to feel bad as consumers about everything we do. A recent Netflix documentary even demonised eating fish. Everything seems to have such a detrimental effect on the plant. I agree that we should focus on sustainable forms of consumerism but it’s impossible to challenge every single decision. You can’t do a deep dive into every company or supply chain when you make a decision about where to eat or what to buy.
On a personal level, for me it’s not just a question of “can ESG investments perform better than non-ESG funds”? I want to align my principles with my investment strategy. You are not just investing for financial returns. You can investing into the future of the planet. After all, what’s the point in building wealth. If you can’t enjoy the world with that money. The cost-benefit analysis of ESG investments then expands to non-tangible returns.
You Can’t Change Everything But You Can Invest In Change
On the other hand, there is a a way we can influence the future. We can fund organisations in favour of sustainability. Those that care about the environment or even those altering their model to pretend to. When it comes to investing, we have seen from both case studies and data that ESG investing is now profit. It’s also becoming more low cost.
The current issue seems to be with how we define ESG investing. For investors it’s not just a case of if ESG investments perform better. It’s also a question of if they meet the desire for sustainability. This does seem to be improving in many ways as the ESG industry evolves and benchmarks develop. Benchmarks that align with consumer preference. We can now invest in funds that benchmark against ESG criteria. Criteria that meets our ethical and investing preferences we can make clear decisions.
Can ESG investments perform better? The evidence seems to be in favour of ESG funds but this is not without some serious caveats. You must fund a fund that meets your criteria when it comes to ethics, social impact and sustainability. Then it comes down to cost. Are you willing to pay the price to align your principles with the fund management fee.
Avoiding Confusion Around ESG
We must be careful when we define the concept of ESG. ESG funds do not necessarily mean ethical funds. This is because ethical is a relative term. The methodologies also differ in how these ethics are applied. There are two core methodologies:
- Negative screening
- ESG integration (re-weighting).
With negative screening the fund excludes negative companies, even entire industries. This is potentially more impactful than ESG integration An integration portfolio re-weighs companies with a negative impact. Whilst they might be present in the fund they will account for a lower allocation of the portfolio. These differing ESG solutions alter the answer to the big question of “can ESG investment perform better?”
ESG Investing: Where Can I Invest?
It can get very confusing trying to identify which ESG fund you want to invest in. Should you want to invest in an index fund that mirrors a clearly defined ESG criteria then you can look to mirror MSCI benchmarks. There are 10s of ‘focus indices’ so I have picked out a couple below. On the iShares website you can filter for funds based on screened, ESG broad and ESG thematic categories.
MSCI Low carbon screened index: Designed to maximize its exposure to positive environmental, social and governance (ESG) factors. This is whilst minimizing the carbon exposure and targeting risk and return characteristics similar to those of the MSCI World Index. As seen in Blackrock’s iShares MSCI ACWI Low Carbon Target ETF
I have some skin in the game when it comes to this index. I recently moved my pension fund to the Fidelity Blackrock World ESG Equity Tracker Fund which mirrors MSCI World ESG Focus Low Carbon Screened Index.
MSCI Screened: The fund seeks to track the performance of an index composed of developed market companies. The index screens out companies associated with controversial weapons, nuclear weapons, tobacco, thermal coal, oil sands, civilian firearms and those violating United Nations Global Compact principles.
How To Find An ESG Fund That Meets Your Goals
Fidelity has over 400 ESG funds listed on their sustainable investment finder. You can filter by a range of sustainable investing categories.
Sustainability focused: Focus on companies that are helping to address environmental and social challenges and show sustainability leadership.
Environmentally focused: Focus on environmental issues and opportunities.
Socially focused: Focus on people issues such as employment, diversity, and human rights.
Ethically focused: Focus on issues relating to personal values, typically by excluding some industries as well as ESG laggards.
ESG weighted: Considers ESG or sustainability issues but aren’t wholly directed by them.
Limited exclusions: Excludes a small number of companies that breach commonly adopted standards on an ESG basis.
Faith based: Focus on faith-based issues and opportunities.
Investing can feel overwhelming for new investors without factoring in sustainability criteria. This is especially when you try to factor in cost and potential returns. Choice is great but it can be confusing. Therefore, I’ve synthesized a list of 7 ESG index funds that make my shortlist.
These are ESG index funds that include companies that meet various sustainability, social impact or governance practices. By contrast they may screen out or weight-out companies with high fossil fuel emissions or other unsustainable practices. Check them out here.
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