The problem with the ESG objective for impact investors
The quality of Environmental, Social, and Corporate Governance (ESG) funds have been diluted both by excess capital inflows and a misconception of ESG practices. These misconceptions have led to the departure of these funds’ selection processes from impact investors’ interests.
The assets of self-proclaimed ESG Exchange-Traded Funds have more than quadrupled since 2017 to more than $100 billion. The capital inflow of sustainable funds has increased by a comparable degree. Due to the increase in assets managed, the selection processes of these funds have become less rigorous. For example, the largest holding of $ESGD, a fund with exposure to “Europe, Australia, Asia and the Far East with favorable… ESG practices,” is now Nestlé, a company that has come under controversy for union-busting, water exploitation, and potential child labor.
To complement this, criticism of the promises made by corporations has led to “greenwashing”, where “green PR and green marketing are deceptively used to persuade the public that an organization’s products, aims, and policies are environmentally friendly.” Greenwashing further complicates the impact investor’s ability to vet companies and allows ESG funds to stray from their stated investment philosophy.
The information technology and healthcare sectors are widely regarded as the most ESG-tolerant sectors. The business models of these companies are more friendly regarding carbon emissions, so reasonably carbon risk is minimized in these sectors. Because of their practices’ commendatory nature, companies in these industries are painted as environmentally sustainable, which they often are. Moreover, due to corporate radicals such as Google and Zappos, these companies’ government structures are portrayed as socially aware.
The implications of this generalization are that companies’ ESG metrics within the information technology sector are often assumed to be better than they are. This leads ESG managers, seeing stability and strong returns, to concentrate holdings into established information technology favorites such as Microsoft; from Morningstar’s parameters, of the ten best-performing ESG funds, the average stake in Microsoft was around 5.6%, while the average of FANMAG accounted for 19% of total holdings. This is only made more prominent by the incredible rise of fund inflows — the quality of these funds’ selection processes may only decrease. For passive investors with the ESG objective in mind, this should be another concern as investors risk over-exposure to specific industries.
As it currently stands, there is a large selection of ESG products available, and investors can pick from funds with unique compositions of investments to funds that mirror the S&P 500 with a few exclusions. The outperformance of ESG investment products in the past year has ratified these positions. And yet, in previous years, the ESG narrative has become malleable, shifting from an ironclad selection regimen to more lenient choices. The concept of ESG has become an abstraction, which, though staying to its core message, has diverged slightly from the standards once held. Depending on how much emphasis an impact investor may place on ESG, some concern towards these decreasing standards is warranted, as concerns over ESG topics, such as wages and workplace discrimination, have gone mostly unanswered.
For the average investor, these investing measures suit them: they are provided apt stability and respectable returns. To the impact investor, however, this should strike a worrying tone. By our writer’s beliefs, no impact investor should feel inclined to invest in a company such as Nestlé, Wells Fargo, or Raytheon. As long as ESG standards remain an abstraction, a vague concept to appease investor and manager interest, the impact of ESG investing will likely be minimal, and investors will default to what produces returns. Alternatively, the impact investor should seek to implement their creed through their own investment methodology.
Note: this article was originally released on December 4, 2020. Due to increased inflows and strain on ESG funds, the ESG objective has only been diluted further.
Written by Phillip Forman and Diego Luca Gonzalez Gauss
