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ETFs and Funds Investing

Buyer Beware: The Different Types of ESG Funds

Investors buy ESG funds because they want to do good. But is it all window dressing and marketing spin?

The problem is that “ESG” is becoming a catch-all for “doing good”, and this is a big mistake.

As the ravages of climate change become increasingly apparent, investor interest in sustainable investing (aka ESG – Environmental, Social, Governance) is growing at an exponential rate. Seeing this trend, asset managers are launching a ton of ESG products.

The problem is that “ESG” is becoming a catch-all for “doing good”, and this is a big mistake. Investors see brochures with pretty pictures of trees, windmills and solar panels and assume that their investment in ESG products will help save the planet.

Trending Up for ESG

I hate to say it, but greenwashing in the investing business is rampant.

The twist is that a lot of it is unintentional.

You see, there are very few people within the asset management industry that truly understand the mechanics of what they’re building and selling. Many industry participants might have an above-average (i.e. more than the general population) understanding, but not deep enough to really get the nuances.

Consequently, product features and benefits can be misrepresented and many investors buying these products don’t have a complete understanding of what they’re buying.

Of those who are more knowledgeable about investing, many appear quite skeptical of the real value of ESG products. A recent informal survey shows this:

The goal of this article isn’t to rip anyone a new one (I’ll save that for other articles). Most people – asset managers and investors – have the best intentions. So instead, I’d like to provide a quick summary of major types of ESG investment products.

Values-Based ESG Funds

Most ESG investment funds use a set of screens to filter out sin stocks, like tobacco, energy and gambling companies. Some use a sweeping approach that removes entire sectors. Others look at revenue sources for individual companies to determine exposure. Regardless of the stringency of the filter, the general idea is to eliminate exposure to companies and industries that don’t align with an investor’s values.

These strategies were originally created to service religions endowments and foundations with strict values-based rules. The purpose is to avoid values conflicts and the effects are largely superficial.

Risk-Based ESG Funds

Similar to Values-Based ESG funds, these funds exclude certain companies or industries based on a set of pre-determined factors. The types of companies or sectors that are excluded might closely resemble those of values-based ESG funds. The main difference is the intent of the fund. While values-based funds seek to align with a set of morals, risk-based ESG funds seek to reduce exposure to risk.

While values-based funds seek to align with a set of morals, risk-based ESG funds seek to reduce exposure to risk.

Companies with poor ESG practices may theoretically be exposed to greater regulation, litigation or reputation risk. These potential challenges affect the ongoing profitability and financial position of certain companies, negatively changing their risk-return profiles. A devastating announcement, for example, could push a the stock of one of these companies down 5, 10, 20% or more. Many ESG funds seek to avoid exposure to these risks.

Conceptually, this is something all fund managers have been doing regardless of whether or not their funds are labeled ‘ESG’. Risk management is part of the investing DNA and ESG risks are simply one of many that are evaluated. Given this, drawing particular attention to ESG risks is more-or-less a outward manifestation of what was already taking place, but perhaps to a more explicit degree.

Values-based and Risk-based ESG funds generally avoid exposure but don’t create change.

Values-based and Risk-based ESG funds generally avoid exposure but don’t create change. This is because the market is not heterogeneous. There are investors that care about ESG considerations and others solely focused on profitability. Therefore, there will always be a class of investors willing to invest in companies with profitable business models, regardless of their ESG practices.

With that said, if a large enough cohort of investors avoids an ESG-offending company its cost of capital could rise. This may prompt company executives to alter business practices (if possible) if company stock trades at a persistent discount. However, avoiding prime offenders like oil producers might only create a market where energy companies trade at a discount, but with little fundamental change to the underlying business. After all, an oil producer exists to produce oil. As long as it has access to capital – which has been proven the case with both the energy and tobacco industries – business will go on with little change (or worse, corporate window dressing).

It is important to understand cause and effect. Cigarette smoking has declined significantly over the decades, but not because Altria’s cost of capital has risen. Altria hasn’t changed its primary business model because many investors have avoided tobacco stocks since the 1990s. Rather, regulation, taxation, education and litigation forced dramatic change to both supply and demand, reduced smoking rates in the developed world.

Impact ESG Funds

The vast majority of ESG funds provide some combination of values-based and risk-based filtering. However, what many ESG investors believe they are actually getting (and what many asset management companies believe they are providing) are Impact ESG Funds.

Most ESG fund investors want to make a difference, but most ESG funds don’t make any difference at all.

Contrary to popular belief, investment funds that seek to make change must actually buy shares of ESG offenders.

Contrary to popular belief, investment funds that seek to make change must actually buy shares of ESG offenders. The recent proxy challenge started by activist investor Engine No. 1 is a perfect example of an investment manager actually making change. Via an activist approach, Engine No. 1 was able to secure 3 seats on Exxon’s board. This could only be done because Engine No. 1 owned Exxon shares, made a shareholder proposal and rallied other shareholders around its cause. These directors will help push Exxon to transform its business to address the risks of climate change. Engine No. 1 recently launched an ETF (VOTE) that will continue with these types of challenges.

How to Choose an ESG Fund?

Before you invest in an ESG fund you must first know what you’re trying to achieve. A good starting point is determining whether you want to align with personal values, mitigate specific risks or create positive change.

From there, look at the company that manages the fund. Who are the portfolio managers and what is their history with respect to environmental, social and governance issues?

What is the company’s historical environmental practices, beyond specific product offerings? Do executives fly in private jets, for example? Does the company have other business lines (e.g. investment banking) that services clients with opposing interests and how will the company overcome these conflicts?

Perhaps most importantly, use of ESG funds doesn’t absolve one of personal responsibility, nor does it replace government regulation and policy. To reduce carbon emissions, communities – individuals, businesses, governments – must work together to achieve common goals.

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