The Current Landscape of ESG Investing
With each passing Earth Day, we are reminded of how imperative our stewardship of the planet is, and how we must take considerable measures going forward to change a host of widespread practices in an attempt to reduce negative human impact on our environment. Earth Day is a day to celebrate the natural beauty of our planet and embrace these efforts to mitigate our harmful practices going forward, no matter how daunting or significant these changes may be. The collective call to action to welcome these changes is all encompassing, and has spawned ESG Investing in the financial industry, which is defined as investing with Environmental, Social and corporate Governance as preeminent values in determining an allocation in a portfolio. While many ESG investors have come to believe in an intrinsic value in investing with these values in mind, and some argue that ESG investing has led to outperformance versus certain indices, ESG does not come without potential roadblocks, risks, and expenses to consider.
The popularity of ESG investing has exploded in recent years. According to Morningstar, ESG fund inflows were double the amount of inflows in 2019, with a total of 51 billion dollars pouring into various strategies last year. This volume of capital allocation to ESG funds is especially remarkable when compared to 2018 figures, with 2020’s final inflow volume nearly ten times that of 2018. [1]
Naturally, with such a considerable rise in popularity there are a number of funds and fund managers that have come into question with respect to their true intentions and the actual values set forth in establishing a given ESG fund. The issue from the prospective ESG investors’ standpoint is that the actual definition of ESG is largely subjective. Judging a company’s ESG values is not always definitively apparent. To demonstrate this with a hypothetical; what would be the best course of action from an ESG fund manager’s perspective if company X carried out questionable practices in disposing materials, but their quarterly guidance was largely focused on the future, and methods in which they would reduce their environmental impact? Many CEOs hold environmental ethics in high regard when considering decisions and best practices in operating their company, but they also have a responsibility to put their best efforts forward in delivering value to shareholders. The latter of these two responsibilities is easier to quantify, and poor performance or company growth is ostensibly far easier to quantify in a boardroom when evaluating CEO performance.
From a fund perspective, managers have a responsibility to allocate capital in a manner that they feel is best-suited for investors, and portfolio managers are under high pressure to deliver returns, otherwise they risk losing their role - the portfolio manager role in the asset management business is fiercely competitive. In some cases this has resulted in scrutiny for ESG fund allocations.
For example, listed below are the top holdings by percentage weight for both the Vanguard US Stock ESG exchange traded fund, and the Vanguard S&P 500 exchange traded fund, respectively. [2] In this case, the ESG investment style is difficult to discern when one looks under the hood at how these separate funds are allocated.
Vanguard US Stock ESG ETF:
Apple: 5.76%Microsoft: 5.25% Amazon: 3.91%Google (Class C): 2.28% Facebook: 2.10% Tesla: 1.52%JP Morgan: 1.37% Google (Class A): 1.35% Vanguard S&P 500 ETF:
Apple: 5.74% Microsoft: 5.29% Amazon: 3.94%Facebook: 2.11%Google (Class A): 1.85%Google (Class C): 1.78%Tesla: 1.53%Berkshire Hathaway (Class B): 1.44% Further, the ESG ETF ($ESGV) has an expense ratio of 0.12%, versus the compared S&P ETF ($VOO) expense ratio of 0.03%.
As was alluded to, it can be difficult to define specific criteria that would deem a company to hold ESG practices. Morningstar has a ranking system (indicated by globes, 1 is low ESG score and 5 is the highest) to quantify ESG. The score is based on a research company’s data. “The Sustainalytics’ company-level ESG Risk Rating measures the degree to which a company’s economic value may be at risk driven by ESG issues. To be considered material to the risk rating, an ESG issue must have a potentially substantial impact on the economic value of a company and therefore on the risk/return profile of an investment in the company. The ESG issues that are material vary across industry groups and companies.” [3]
Overall, if not for the value of environmental stewardship itself, some investors subscribe to the notion that a company that holds ESG values in high regard is proactive in addressing issues, and is adept at embracing changing business practices, and thus could be better positioned to perform well in the long run. The willingness of a given company to embrace new and developing values and practices could serve as an indicator that the company is not stagnant in their management or business operations processes.
To further quantify the growing value in ESG practices, CFA Institute cites that the number of large global companies that disclose their greenhouse gas emissions and water management and climate change strategies to CDP, an environmental nongovernmental organization, rose from 295 in 2004 to 5,003 in 2014. [4] In my view, it is likely that ESG values in investing continue to grow, and will move increasingly to the forefront of managers’ and investors’ decisions to allocate capital. However, there are undeniable growing pains in deploying these new strategies, but it can be argued that any new ideology demonstrates this. The most important factor for ESG investors to consider is due diligence in selecting funds and managers with honorable intentions and thoroughly analyzed investment backgrounds, as well as maintaining cognizance of bad actors or practices in the space.
Disclosures & Sources:
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All investing involves risk including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
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