ESG portfolios are still plagued with greenwashing worries

Eth­i­cal invest­ing is now a dri­ving force in the world of finance, with investors demand­ing high stan­dards in envi­ron­men­tal, social and gov­er­nance (ESG) issues. How­ev­er, the mar­ket remains imma­ture, with a lack of con­sen­sus on how ESG should be defined and mea­sured. 

Every year more mon­ey flows into funds that meet ESG cri­te­ria. Total ESG assets under man­age­ment (AUM) sur­passed $35tn (about £26bn) glob­al­ly in 2020. That was a third of over­all AUM and up from $22.8tn in 2016, accord­ing to the Glob­al Sus­tain­able Invest­ment Asso­ci­a­tion.

At one time, the received wis­dom was that prof­its and prin­ci­ples didn’t mix. How­ev­er, a grow­ing body of evi­dence sug­gests com­pa­nies with good ESG prac­tices tend to out­per­form their less eth­i­cal peers. Ana­lysts S&P Glob­al Mar­ket Intel­li­gence tracked 27 US-based ESG exchange trad­ed funds and mutu­al funds between Decem­ber 2020 to May this year and found that 16 out­per­formed America’s S&P 500 index. The funds – which each had more than $250m in AUM – rose between 11% and 29.3% dur­ing the peri­od ver­sus 10.8% for the bench­mark. 

It’s clear that investors today expect com­pa­nies to take a stand on issues like cli­mate change and work­ers’ rights, a trend that’s been fur­ther fuelled by Covid-19. Accord­ing to a sur­vey this year from eth­i­cal bank Tri­o­dos, about a third (32%) of Britons who have invest­ments said the pan­dem­ic had moti­vat­ed them to explore invest­ing in an eth­i­cal fund, up from just 22% in 2020.

Stu­art Kirk is glob­al head of research and respon­si­ble invest­ments at HSBC Asset Man­age­ment, which has $621bn of AUM. Its data, which cov­ers the last 10 years, shows that in the US, Europe and Asia (exclud­ing Japan), a long-only port­fo­lio of the top 30% of com­pa­nies by ESG score, equal­ly weight­ed and relanced month­ly, pro­duced excess risk-adjust­ed returns, he says. 

“Over time, as this sto­ry becomes bet­ter known, we believe that ESG strate­gies will com­prise a grow­ing pro­por­tion of out­stand­ing assets.”

Greenwashing fears

Despite the strong returns on ESG-linked invest­ing, there are bar­ri­ers to its adop­tion. It’s very hard to mea­sure the real-world impact of such invest­ments, while there’s also a lack of firm, shared def­i­n­i­tions of ESG. This allows some firms to present them­selves as more eth­i­cal than they are, known as ‘green­wash­ing’. 

Cur­rent­ly, list­ed com­pa­nies can decide how much infor­ma­tion they dis­close about their ESG per­for­mance to the mar­ket. Many report selec­tive­ly, crit­ics say. Rat­ings agen­cies offer inde­pen­dent assess­ments, but they have to work with the infor­ma­tion avail­able to them and can be impre­cise. 

It’s led to strik­ing anom­alies. For exam­ple, oil com­pa­nies have appeared in the hold­ings of ESG invest­ment funds because they’ve invest­ed heav­i­ly in renew­ables and thus have high clean ener­gy scores. The fast fash­ion firm Boohoo was also pop­u­lar among ESG funds until it was caught up in a work­er exploita­tion scan­dal in 2020. The com­pa­ny, which at the time said it was unaware of the alleged issues in its sup­ply chain, had been rat­ed high­ly by agen­cies for its treat­ment of work­ers. 

Cathrine De Con­inck-Lopez is glob­al head of ESG at Invesco, an invest­ment man­age­ment com­pa­ny with $1.5tn in AUM. She says the ESG mar­ket “suf­fers from lack of com­mon def­i­n­i­tions, inter­pre­ta­tions and edu­ca­tion” and data avail­abil­i­ty is an issue. 

“In addi­tion, it is a fast-mov­ing area that is try­ing to match real-world issues such as cli­mate change, bio­di­ver­si­ty, diver­si­ty, human rights to a more tra­di­tion­al and in some ways arms-length finan­cial ser­vices indus­try. As such we are find­ing a need for con­stant inno­va­tion in process­es, data and sys­tems.”

Aware of the prob­lem, reg­u­la­tors are seek­ing to change the rules on dis­clo­sure, with the Sus­tain­able Finance Direc­tive Reg­u­la­tion in Europe and the Sus­tain­able Dis­clo­sure Require­ments in the UK. De Con­inck-Lopez says “a com­mon base­line” should help set a min­i­mum stan­dard and raise the bar for the indus­try over­all.

Myriad approaches

How­ev­er, many new­com­ers to ESG find the myr­i­ad dif­fer­ent approach­es tak­en by funds bewil­der­ing. There’s an alpha­bet soup of ESG strate­gies out there, from neg­a­tive screen­ing and social­ly respon­si­ble invest­ing (SRI) to impact and sus­tain­able invest­ing, all of which deter­mine how port­fo­lios are con­struct­ed, the degree to which philo­soph­i­cal views are expressed and the extent of social impact. 

The most pop­u­lar approach cur­rent­ly is “ESG inte­gra­tion”, where ESG cri­te­ria is incor­po­rat­ed into invest­ment deci­sions to help enhance risk-adjust­ed returns, regard­less of whether a strat­e­gy has a sus­tain­able man­date. It’s more light touch than some­thing like impact invest­ing, which mea­sures envi­ron­men­tal and soci­etal out­comes against spe­cif­ic KPIs, but may not gen­er­ate such reli­able excess returns. 

Inte­gra­tion chimes with what many investors want, research sug­gests. About 90% of HSBC Asset Management’s ESG assets are man­aged this way, says Kirk. 

For some­one look­ing to invest in ESG, it’s cru­cial­ly impor­tant to under­stand whether they’re invest­ing in such fac­tors pri­mar­i­ly because they believe the approach gen­er­ates excess returns or whether they’re doing it sole­ly with respon­si­ble or sus­tain­able objec­tives in mind, Kirk says. “These are two very dif­fer­ent ideas about ESG, and they are not always aligned.”

Long-term potential

For now, investors must do their own research on whether an ESG invest­ment is right for them. Scep­ti­cism is grow­ing about how vir­tu­ous invest­ments real­ly are, which some fear could lim­it the sector’s growth poten­tial. Accord­ing to Triodos’s research, a quar­ter (26%) of con­sumers who say they would not cur­rent­ly invest in an eth­i­cal fund also ques­tion how eth­i­cal many ESG invest­ments tru­ly are – up from 17% in 2020.

Yet while green­wash­ing fears may be valid, the very fact that some firms feel they must pre­tend to be eth­i­cal shows just how much atti­tudes have changed. With every pass­ing year list­ed com­pa­nies face grow­ing pres­sure to act more respon­si­bly. Those who shirk such oblig­a­tions pose a grow­ing risk to their investors, says Ainslie McLen­nan, head of bal­anced funds UK at Nuveen, a fund man­ag­er with $1.2tn AUM.

For exam­ple, as we shift towards a low car­bon econ­o­my, invest­ments in fos­sil fuel inten­sive assets will become high­er risk, los­ing val­ue at some point, she says. 

“It is very dif­fi­cult to iden­ti­fy exact­ly when that point will come, but there is an obvi­ous dan­ger of a tip­ping point. Con­verse­ly, assets that have a clear path­way to net-zero car­bon present the great­est poten­tial for long-term val­ue growth. There­fore, eth­i­cal invest­ment seems to present bet­ter risk-adjust­ed returns.”