Here’s something we’ll bet you already know: there has been pushback in certain circles against investing based on environmental, social, and governance (ESG) criteria. While often described as “anti-ESG”, some—not all, but some—of that pushback is not actually an objection to ESG per se. It stems from a suspicion that some asset managers, mutual funds, and/or ETFs that claim to “do” ESG are basically faking it. (Note: this is not the same as a given company making claims about its “green” practices, which is bad in its own way and has led to lawsuits.)
The objection is that the asset management community knows that sustainable investing is extremely popular with both institutional and individual investors and many firms want a piece of that pie. So, as the cynics claim, some of these managers simply cook up a good marketing story and an ad campaign without really doing work to determine which companies have superior ESG practices. In other words, they are “greenwashing.”
Sadly, this is probably true in some cases. The good news is that it is harder to get away with greenwashing now than it used to be, due to disclosure requirements have been established in many countries (not in the U.S., although the SEC has proposed a couple). The bad news is, while the possibility of greenwashing is a legitimate concern, there are other reasons investors may be confused about whether a given “sustainable” fund is pursuing its stated objectives.
We’re going to try to clear up the confusion here. Let’s have a go, shall we?
Yes, greenwashing happens. A fund manager who decides to pursue greenwashing might do something like this:
- Think of a good fund name (“Invest to Make the World a Better Place and Still Earn a Good Return” is too long for a fund name, but that’s the idea). Create ads with pictures of trees or solar panels, and maybe a gathering of people of various racial backgrounds who are cooperatively engaged in some productive activity—that sort of thing.
- Buy the stocks in a chosen benchmark, but tweak the weights a bit so that the fund doesn’t deliver the exact return as the benchmark. Reduce exposure to sectors that are environmental “villains” (probably coal, oil & gas). Increase weights for solar energy firms and some ESG “favorites” such as Apple, Microsoft, and Coca-Cola. This can be automated so that it costs the asset manager almost nothing to execute.
- Revisit the weights once a quarter and “rebalance” – that should take less than a day.
Use Vendor Scores to “Tilt”
Putting aside the hint of cynicism you may have detected in the previous section, there are “legit” ESG funds that can appear as though they are greenwashing. This is because their approach is to stay fairly close to a benchmark but “tilt” (toward and/or away from) certain sectors or companies based on scores published by one or more ESG vendors. Their rules could be something like, “we overweight the stocks whose ESG scores are higher than the median score for a given sector, and underweight the stocks whose ESG scores are below the median.”
Critics point their fingers and exclaim, “that fund isn’t really doing ESG investing; its returns and weights are close to the benchmark.” But that’s by design! The fund is giving investors a way to almost track a benchmark (the S&P 500 or whatever) while using investment dollars to emphasize or de-emphasize certain companies based on their alignment with the fund’s stated sustainability / ESG goals. This has legitimacy provided you, the investor, (i) don’t seek more than what this approach promises, and (ii) have confidence in the underlying ESG scores that are used to over-and underweight the stocks in the benchmark.
The latter part of that previous sentence is worth dwelling on for a moment. Much has been written about why different vendors’ scores can vary wildly for a given company – see this article by the CFA Institute, for one. One reason is that some vendors may put more weight on E versus S or G in coming up with a total ESG score; others may assign them equal weights, but there are many others. Here is just one depiction of the lack of consistency between two well-known ESG vendors’ ratings:
Visuals courtesy of BDO USA, LLP ©2021 BDO USA, LLP. All rights reserved.
A fund that relies on a particular vendor’s scores to tilt the weights of its holdings buys into that vendor’s approach. That approach may or may not be consistent with your goals for investing in sustainable companies, but it doesn’t mean the fund is “greenwashing.”
Some accusations of greenwashing are leveled at funds that go a step beyond “tilting” and hold only those stocks whose ESG scores are in the top half, or top third (or top whatever percentile the fund chooses) in a universe of stocks. This is typically done by sector; otherwise, the fund would likely end up holding mostly large-cap tech stocks, which tend to have better ESG scores in an absolute sense than small-caps and energy stocks.
This is often referred to as a “Best-in-Class” approach – within a given category (e.g., sector), choose the best and shun the worst. Of course, this suffers from the same problem described above–it is highly dependent on the assumptions embedded in the ESG scores used to rank the stocks in each sector. We wrote about the commotion that arose when S&P dropped Tesla from its ESG index. “How can the pioneer in EVs be dropped from an index that purports to be ‘ESG’?!?!” As S&P explained, Tesla’s overall ESG score had declined while other automakers’ scores had improved; thus, it no longer made the cut. Just following the rules–nothing nefarious going on.
A fund that uses a Best-in-Class approach to ESG investing will emphasizes environmental considerations over social and governance issues ONLY if the scores used to rank the stocks in the investment universe emphasize E over S and G. That means a company that helps the environment but treats its employees poorly and lacks diversity and independence in its board of directors may be dropped from this type of ESG fund for wholly legitimate reasons – that’s not greenwashing.
How about ESG funds that claim to construct a portfolio of stocks based on each company’s exposures to ESG risk factors and opportunities? How can we know that the fund is actually doing that (which would justify paying its active management fees)? Funds can say they use a range of inputs to analyze companies’ E, S, and G practices. They can say they go beyond ESG scores to look at the raw data, reading corporate social responsibility reports, and engaging with company management. But is that true?
It’s possible that some of these funds are just telling a story that they know will appeal to a growing percentage of investors. How could we tell? We can’t assume that a “real” ESG fund would deliver better returns than non-ESG funds. There is evidence to suggest this is true over time—and may be partly due to the fact that companies headed by management teams that do a good job on sustainability issues are likely to do a good job managing the company overall—but it’s not a litmus test. The issue of ESG and excess returns is complicated (and beyond the scope of this article).
We think the best way to see whether an actively managed fund has valid ESG “credentials” is to look at its ESG exposures. That requires access to detailed data. Even without a concern about greenwashing, investors may have E, S, and G priorities that may not match a fund’s definition, so looking at detailed data can be the best way of choosing among ESG funds.
OWL’s data and analytics are often used to assess funds’ ESG exposures across the categories that are of most interest to the investor. This can be particularly helpful in the advisory space where advisors want to incorporate their clients’ ESG priorities in selecting the funds that are best for each individual client. Contact us to learn more about our capabilities in this area.