ESG. Investing based on environmental, social, and governmental factors. The idea is simple. Investors want to invest in companies that reflect their values. Climate change, racial and gender equality, human rights, and so forth.  

Money managers and mutual fund companies are in a race to create ever more product to meet this growing market. It is estimated that over $220 billion is invested in ESG, growing to $1.2 trillion within ten years. (i) It has been said that ESG is the biggest thing to come along in the financial world since the introduction of exchange traded funds (ETFs) two decades ago. 

But you shouldn’t confuse ESG investing with doing good. It’s more complicated than that. And it’s worth taking a closer look. 

The history of ESG began in 2004 at the United Nations. Kofi Annon, then Secretary-General of the UN, called on over 50 world financial institutions to participate in a joint initiative under the auspices of the UN Global Compact, with the International Finance Corporation and the Swiss Government. The goal of the initiative was to find ways to integrate social responsibility into capital markets.  

Out of this initiative came a study which coined the term ESG. At the same time, the UNEP Finance Initiative issued a legal framework for integrating ESG into institutional investing. These two documents provided the framework for a flurry of activity that followed: the launch of the Principles for Responsible Investment (PRI) by the NYSE in 2006, and the Sustainable Stock Exchange Initiative (SSEI) and 17 Sustainable Global Development Goals (SDGs) by the United Nations shortly thereafter. Since then, a number of other initiatives have appeared on the scene, including the GRI Standards (GRI), the International Integrated Reporting Initiative (IIRC), and the Sustainability Accounting Standards Board (SASB). Although they all sound very official, there is no one standard or organization governing this growing field. 

Of course, the concept of socially responsible investing goes back even further than this, typically characterized by avoidance of certain investments. For years, many investors or funds chose to avoid tobacco, firearms, and gambling, or to restrict investments in certain countries like South Africa. ESG investing, by contrast, is based on the idea that investments should be affirmatively pursued by investing within a framework of environmental and social goals.  

Like many things that start with government involvement, the devil is in the details. How are the ratings determined, and who does them? Unfortunately, there is no clear answer.  

There are many providers of ESG ratings, and their ratings differ widely. They include Bloomberg, KLD (MSCI Stats), Sustainalytics (40% owned by Morningstar), RepRisk, Video-Eiris (Moody’s), Asset4 (Refinitiv), Thompson Reuters, RobecoSAM (SP Global) and Institutional Shareholder Services (ISS). According to a study by the MIT Sloan School of Management of five prominent ratings firms, the correlation of ESG scores was 0.61 (where 1.0 equals perfect correlation). This suggests a very wide variability of scores for the same company, based on who is doing the rating. This can be compared to the correlation of 0.99 for  bond ratings issued by S&P and Moody’s.   

Part of the problem, of course, lies in the complexity of the subject matter and the fact that these ratings are subjective. ESG scores are based on the three pillars of environmental, social, and governmental factors, and anywhere from 10 to 14 underlying themes. The themes are often further broken down into dozens of key issues to capture different concepts within the E, S, and G pillars. And every rater employs a different methodology.

But good ESG scores don’t necessarily indicate that a company is actually providing ESG outcomes. The process of generating an ESG score ultimately reflects how well a company may be positioned to face future risks and opportunities, and how it compares to its industry peers. The results can be surprising.  

An interesting example is in the auto industry, using Sustainalytics ratings on Yahoo Finance. Tesla has an ESG score of 31 points (60th percentile), while Volkswagen, which was embroiled in an emissions scandal for years, has a better score of 41 (86th percentile). Or in banking, where JP Morgan Chase has a score of 22 (27th percentile) while Wells Fargo has a score of 31 (59th percentile). 

There are many reports touting ESG and claiming that companies with high ESG scores generate superior returns. But the wide variability of scores can lead to a variety of conclusions. It is also worth noting that tech stocks tend to be overweight in many ESG funds, while energy and materials are underweight. This is, of course, also true of the broader market, where tech stocks have become the largest components of the S&P. It may very well be that financial factors, such as return on equity, leverage, and market capitalization (and not ESG metrics), explain most if not all of these reported “superior” returns. And, of course, only well-capitalized companies have the resources to devote to ESG issues and to artificially enhance their ESG scores.  

So, what to make of the trend toward ESG investing? Perhaps the best advice comes from Wall Street sage Burton Malkiel (A Random Walk Down Wall Street), who suggests first putting the core of your portfolio in a broad-based index fund. Then, if you want to invest in a specific field like renewable energy, invest directly in a renewables company or an ETF focused on renewables. 

We believe that our All-Weather Core portfolio offers a more sophisticated solution than the above by balancing risk allocations through the use of broad-based index funds.

In summary, if you put all your eggs into a passive, broad-based ESG basket, you may be surprised by what you get!