Sustainable Investing: The ESG Water Can Be Murky

Over the past several years, an increasing number of investors have become interested in aligning their portfolios with their values, seeking investments they view as sustainable. Wall Street—always quick to capitalize on a trend—has taken note. The number of sustainable investment funds, often incorporating environmental, social, and governance (ESG) factors in their investment processes, has tripled in just the past five years. By some estimates, roughly a third of every dollar under professional management in the United States today is subject to some sort of sustainable investing criteria or factors.

On the surface, this may seem like a positive development—a wealth of new products for investors to choose from. But as with all things pitched by Wall Street, a healthy dose of skepticism is warranted.

In the Beginning

While the number of sustainable investing funds available today is greater than in the past, the idea itself is not new. Socially Responsible Investing (SRI), a sustainable investing movement similar to ESG, has been around for decades.

SRI’s initial focus was rather narrow and tended to concentrate on boycotting certain “sin stocks”—historically companies involved in selling tobacco, liquor, or firearms. But increased attention to climate change in recent years and more vocal calls for social activism have driven new interest in the field. SRI’s goals have largely been absorbed into the broader ESG movement, resulting in investment restrictions that reach beyond a few narrow categories.

As Currently Defined Sustainable or ESG factors are non-financial criteria applied to the analysis of investment options. For example:

• Environmental factors such as a company’s carbon emissions, impact on climate change, or record on pollution, waste stream management, and recycling.
• Social factors including progress when it comes to gender, diversity, and inclusion in the workplace as well as more general concepts such as customer satisfaction and employee engagement.
• Governance factors like the diversity of the boardroom, policies on executive compensation, and exposure to legal and regulatory risks.

Unfortunately, there is no definitive list of ESG criteria, and many ESG factors may be connected or overlap.

Murky Waters

The lack of clearly defined ESG criteria and competing interests has opened the door to a proverbial gold rush as Wall Street competes with itself for customer dollars. Investors should proceed cautiously for several reasons:

• ESG funds are generally more expensive than other fund types with similar industry or stock exposure. Passive, or indexed exchange traded funds (ETFs) marketed as ESG carry an average fee that can be significantly higher than popular alternatives. And the fee difference is even higher for actively managed ESG mutual funds.
• Higher fees might be justified if ESG funds delivered better performance, but with the exception of2020, they have largely failed to do so. (ESG funds tend to overweight technology stocks, which performed better than the broader market last year. While technology stocks have a lower environmental footprint than manufacturers, for example, they still need to make progress on diversity and inclusion.) Interestingly, some research has found that the holdings of many popular ESG funds are nearly identical to those of the S&P 500 index. This implies that these ESG funds are simply expensive indexers.
• Regulation regarding the marketing of sustainable and ESG investment products has not kept pace with the proliferation of products. In the void, many fund companies have seized the opportunity to poorly performing legacy funds as ESG with little change to the fund’s underlying management or approach (a process called “greenwashing”). And because the definition of ESG varies widely, many so-called ESG funds invest in carbon emitters, gun manufacturers, and junk food companies that manage to satisfy the investment manager’s ESG screen. The SEC is aware of these issues and has recently stepped up its regulatory efforts, but this may have little impact on the growth of ESG funds.

This is not to dismiss all sustainable funds out of hand. An ESG fund may in fact be an appropriate option for an investor, but as with all investments, due diligence is key.

What is the Conscience-Driven Investor to Do?

Given the pitfalls, investors interested in ESG investing may be left wondering how to proceed. We believe incorporating sustainable investment principals into portfolios is possible, and it starts by understanding the end goal: the values, beliefs, and objectives an individual investor is targeting. Sustainability means different things to different people, so it’s important to be clear about an investor’s aims. With this knowledge, a portfolio can be crafted to achieve the given objectives. At Mitchell Sinkler & Starr, we have the advantage of tailoring our approach to suit our clients, using stocks or—with very careful due diligence—funds that satisfy their goals. It turns out that old-fashioned attention to detail may be the best answer to satisfy newly heightened interest in sustainable investing.