Investment

With untrustworthy indices and oil at record highs, ESG investing has never looked so questionable

The $30 trillion ESG movement is in torment as arguments rage over how funds should be structured and stay relevant in the wake of the market crash and war in Ukraine.

Rather than ESG, family offices are already opting for impact deals backing well-defined opportunities which produce benefits for society, as well as financial returns.  Professional body Society of Trust and Estate Practitioners (Step) has come out in favour of the circular economy, arguing that family businesses can thrive by avoiding the waste of resources and talent. 

So oil major Exxon happily sits in S&P 500’s ESG index, while Tesla has been dumped despite its leadership in electric cars, batteries and solar energy

It was nearly forty years ago, in 1983, that Eiris Foundation started to develop data which grew into the Environmental, Social and Governance movement. Since then we have seen the blossoming of a vast range of strategies.

But everyone has a different idea on how to progress things. In an MIT survey, a team led by Florian Berg studied 709 EFG indicators used by six rival rating agencies: KLD, Sustainalytics, Moody’s, S&P Global, Refinitiv and MSCI.

It found the overlap of viewpoints averaged no more than 54%, ranging between 38% and 71% for different factors.

Asset managers have also developed rival ESG ratings. Their views can come from conviction but, more often, become marketing tools. Pay, after all, is based on success in winning business, as opposed to winning a debate over ESG.

In contrast, the correlation between credit ratings is tight because views used broadly-accepted audited data, which is also a springboard for the pricing of stocks and bonds.

In contrast, ESG proponents use different data from various sources. Manager Robeco SAM once said it uses 600 data points from each company, based on 100 questions. Which leaves plenty of scope for disagreement. 

It gets worse. African consulting firm Intellidex argues that ESG strategies hold back impact investing in emerging markets, favoured by the United Nations, because of their caution over perceived governance or social failings. 

Regulators in the European Union and US are far apart. Rows in the EU over whether nuclear energy and gas should be classed as “green” fuels have been taking place for months. Corporate inertia means standard setters are nowhere near embedding ESG into global accounting standards, still less financial statements.

The lack of efficiency in the ESG sector has started to worry the SEC, the US regulator. It is campaigning for greater transparency, fining BNP Paribas for a false claim that its mutual funds had undergone an ESG review prior to September 2021. The SEC is also probing the alleged shortcomings of Goldman Sachs in branding ESG funds.

Intech International likes to manage systematic mandates based on mathematical clarity. There’s not much sign of that with ESG. International president David Schofield said: “One of the biggest challenges facing ESG investing, in my opinion, is the lack of some kind of standardised approach to assessing companies’ ESG credentials.”

He believes the confusion imposes a tax on the attention of investors, plus the risk that ESG will be diluted to oblivion. 

Controls over ESG funds have already been diluted because promoters seek to reassure institutional clients their performance will not deviate far from mainstream indices.

ESG-lite includes “best of class” stocks for each sector even when the sectors in question are far from green. They are biased to large-cap stocks, even though smaller stocks tend to be more innovative.

With a fair wind from technology stocks, the MSCI ESG Leaders index has risen by a total 179% against 167% from mainstream equivalents since 2009. 

This year, however, ESG funds have come under pressure, as natural resource stocks have risen, at the expense of tech and ESG growth stocks have crashed. Bloomberg has reported that $2 billion flowed out of ESG ETFs in May.

The onset of the Ukraine war has led to questions over whether ESG really needs to be a priority when weapons, oil and gas need to get in the right hands to serve the interests of Western society. According to data provider Util: “ESG was never going to be popular in a recession ruled by eye-watering oil prices. “

So oil major Exxon happily sits in S&P 500’s ESG index, while Tesla has been dumped despite its leadership in electric cars, batteries and solar energy.

S&P cites workforce and racial issues at Tesla, but fans of ESG-lite would grasp that Exxon’s shares are more likely to perform better than Tesla, right now. 

Investors in ESG funds are becoming sceptical over the whole exercise. According to a poll by 2 Degree Investing, 86% of respondents argued E, S and G corporate scores should be scored separately. A majority said ESG should be scrapped altogether. 

HSBC commentator Stuart Kirk, now suspended, recently argued that climate risks were overblown, asking if anyone cared about Miami being underwater in 100 years. 

His remarks paid little heed to science, including the risk of runaway climate change, but he played to a gallery tired of being told what to do by the ESG brigade.

Rather than wrangling over definitions, and rigging indices, the ESG brigade needs to develop a unified voice.

Util says the time has come to analyse funds more deeply by working out which contributes the most, and the least, to impact objectives developed by the UN.

Step, the professional body, has produced a brochure saying families need to apply a sustainable approach to their own governance, based on the circular economy. 

It says: “Circularity, in broad terms, means both avoiding and finding value in ‘waste’ – not only of natural resources but also of the human resources within families. 

“This includes family members not directly involved in a family business but who have a stake in the future and who need to support those in more active roles.” 

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