By Marjorie F. Smith, CFP®
Environmental, Social & Governance (ESG) investments: Are you able to distinguish between fashion and substance?
“Enlightened Self-Interest” is the practice of helping others and thus, helping ourselves. Reflecting this ideal in the financial markets is the currently wildly popular ESG movement.
ESG stands for Environmental, Social & Governance. ESG funds originated from investors’ desire to align their values with their investing. They wanted to be socially conscious with their money, supporting ethical behavior and social causes important to them, without sacrificing returns. They also wanted some standardization and for a third party to do the vetting for them. The ESG criteria and designation allow investors to evaluate investment opportunities based on not only the financial data but also on what many consider to be moral grounds.
For example, funds that meet the ESG standard may have satisfied rating agencies based on companies’ diligence regarding reducing greenhouse emissions, their treatment of employees, compensation parity between men and women, diversity of its Board of Directors, etc. Sometimes there are discrepancies. The Dow Jones Sustainability Index may include a company based on its humane treatment of animals while Bloomberg ESG Data Service may exclude that company for lack of diversity among executives. Different rating agencies have their own set of criteria, but their job is to do the screening for investors who care about “socially responsible” investing.
Many investors care a great deal. Morningstar reported that investors pumped $15.7 billion into ESG during the third quarter of 2021, with ESG funds totaling $330 billion as of September. Bloomberg has projected that by 2025 ESG assets will represent more than a third of the $140.5 trillion in projected total AUM.
Many market-watchers welcome the popularity of ESG funds. They argue that, at best, ESG can promote positive change while improving investors’ returns. They argue that treating people, animals, and the environment well is good for business. A stronger, well-funded company will have increased returns to investors. At worst, singling out companies and funds that meet ESG criteria is harmless, supporters say.
Dr. Alex Edmans, Professor of Finance of the London Business School, is an ESG defender. In a Nov. 8, 2021, interview with the Wall St. Journal’s William Power, he argued that most ESG investors have no illusions and are primarily making a sound financial decision:
Most true ESG investors…don’t make unsupported claims of impact; their marketing argues that ESG’s main effect is to improve long-term returns rather than change company behavior.
He believes that investors must hold companies accountable for “key ESG dimensions” that are impossible to quantify or regulate, such as corporate attitudes and culture.
Others are skeptical if not critical. In the same article, Tariq Fancy offers the dissenting view. Formerly a chief investment officer in sustainable investing at Blackrock, Fancy has called ESG a “dangerous placebo.” He says the ESG products are overpriced with “little or no impact and narratives that mislead the public and delay the government reforms we need.”
Other concerns are that the ESG screening process is flawed, either intentionally disingenuous or just naïve. They point to its subjective nature and vulnerability to corruption. They worry that investors are being duped. Put bluntly, they say that the ESG movement is a marketing scam that ultimately benefits those who collect management fees and raise capital.
Pacific Wealth Management® takes a milder view than Mr. Fancy, with discernment on our clients’ behalf. For those who express a desire for values-based investing, we investigate whether an ESG fund truly reflects the client’s values, while being appropriate for his or her investment goals:
- We initially consider a fund after utilizing financial data filters, before taking into account the ESG component.
- We consider the nature of each credit rating agency and identify the exact criteria they use in rating ESG funds
- We discuss the specific social issues that matter to a client. Sometimes it is best to select a narrowly-defined ESG fund. For example, if gender equality matters most, we may recommend a fund that meets gender-lens investing criteria instead of general ESG criteria.
- We ensure that the internal management fees of any fund under consideration are reasonable. We evaluate how they compare to non-ESG funds.
At Pacific Wealth Management®, we believe that values-based investing and investment performance are not mutually exclusive and you do not have to sacrifice returns to satisfy your conscience. We do not, however, recommend an ESG fund to a socially-conscious investor simply because of the ESG designation. We take care to clarify the client’s non-financial priorities and then make investment recommendations that integrate those priorities with the client’s financial goals.
Contact us to discuss how you can maximize the positive impact that your invested funds may have on both your portfolio and on the causes that are dear to you.