The practice of investing based on environmental, social and governance (ESG) criteria has become increasingly popular over the years. Last year was a banner year for cash inflows to ESG funds, with these funds reaching a record of approximately $330 billion in collective assets under management according to data from Morningstar.
At its core, the original intention of ESG investing was to provide an incentive to fund companies that will make the world a better place, netting investors superior returns in the long run because their investments will avoid common corporate pitfalls like salting the earth you farm, while at the same time helping the world become more prosperous.
In practice, however, these ideals have so far turned out to be impossible to implement. Instead, ESG investing has become heavily skewed toward large-cap companies with business models that are perceived to be sustainable in the long run, adhering to a small portion of the social and environmental components while eschewing the governance component. In other words, ESG investing doesn’t actually work.
Breaking down ESG funds
To see why ESG isn’t the feel-good, high-return dream that it’s made out to be, the first thing we need to do is look at what companies actually make up the biggest portions of these funds.
The top 10 companies according to MSCI ESG criteria are Nvidia (NVDA, Financial), Microsoft (MSFT, Financial), Best Buy (BBY, Financial), Adobe (ADBE, Financial), Pool (POOL, Financial), Salesforce (CRM, Financial), Cadence (CDNS, Financial), Intuit (INTU, Financial), Idexx Laboratories (IDXX, Financial) and Lam Research (LRCX, Financial).
Right off the bat, we see that these stocks all have several things in common. For one, they all qualify as at least large-caps, with some mega-caps mixed in as well. For another, none of these companies really needs even more money in order to grow. These aren’t startups trying to get off the ground, in need of investment to get the ball rolling; they’re well-established companies that are perfectly capable of attracting investors without the ESG story.
One of the major ESG exchange-traded funds is the iShares ESG MSCI USA Leaders ETF (SUSL, Financial). Its top holdings are Microsoft, Alphabet’s class A shares (GOOGL, Financial) and Tesla (TSLA, Financial). Again, we see mostly large, well-established companies that aren’t particularly in need of more investors.
Another big ESG ETF is the American Century Sustainable Equity ETF (ESGA, Financial), which counts Apple (AAPL, Financial) as one of its top holdings. Interestingly, this ETF also has exposure to Lockheed Martin (LMT, Financial), which is about as far from ESG criteria as it gets.
For those that want to track the S&P 500 but in a more ESG-friendly fashion, there’s the SPDR S&P 500 ESG ETF (EFIV, Financial), which does exactly what it says on the tin. Its top holdings are Apple, Microsoft and Alphabet.
The iShares MSCI KLD 400 Social ETF (DSI, Financial) takes things to an extreme of sorts. Its top holdings are the usual suspects - Microsoft, Alphabet and Tesla - but it notably excludes a lot of things, even nuclear energy, which is a clean energy source, and alcohol, which can be made in an environmentally friendly way. Its goal is to cleanse itself of any stock that might be considered morally impure.
A rose by any other name
So we see the relative uniformity of the top holdings of major ESG funds; it’s all a wall of Microsoft, Apple, Alphabet, Tesla, etc. When we take note of this, it’s no wonder than many ESG funds are performing in line with or better than the market average.
Does that mean ESG works? Absolutely not. In fact, you could say it means that ESG has failed on the fundamental level.
If the idea of ESG is for investors to help companies, Microsoft doesn’t need your help. If the idea of ESG is to help the environment, you’ll have more of an impact planting some trees or doing your own research to find clean energy startups that need help getting off the ground.
If the idea is to get higher long-term returns by investing in companies that rank highly based on MSCI or other ESG criteria, you might as well consider Microsoft, Apple, Alphabet and Tesla, since those are the highest-weighted holdings in many ESG funds and, therefore, the drivers of their past success.
ESG has become just another name for the same companies that the market already holds dear. To some, though, these companies seem more attractive when packaged under the ESG label with quotes of their plans to go carbon-neutral soon.
So why didn’t ESG work out as planned?
There are several reasons why the ESG investing movement failed to take off like it was supposed to, but the three main ones are the difficulty of measuring ESG criteria, gravitation toward the “best” and the prevalence of greenwashing.
How do you measure whether a company is doing good on environmental criteria? You can try looking at statistics like weighted average carbon intensity or a breakdown of energy sources, but these often don’t take into account the carbon footprint of wherever the company buys metals and other materials from. For social, you could look at percentages of gender and race and pay levels among employees, but how do you measure sweatshop labor from operations that are outsourced to poorer countries? A lot of the times, the answer is that you can’t, so ESG ratings are made up of statistics that miss a lot.
Secondly, when ESG funds are looking for which stocks to invest in, they are typically only looking for one thing: immediate and lower risk returns. This means a natural gravitation toward the “best” companies that rank the highest on ESG statistics and have provided attractive historical returns. It also means that sometimes, they might mix in the stocks of companies like Lockheed Martin, which run counter to the goals they claim, in search of higher returns.
Lastly, those offering and investing in ESG funds often aren’t really interested in doing good for the world so much as they’re interested in either feeling good about themselves or appearing good in other people’s eyes, i.e., greenwashing. This attitude doesn’t lend itself to an interest in whether or not the companies in ESG funds are really environmentally friendly.
Takeaway
In summary, while ESG investing may seem like an excellent idea on the surface level, in terms of implementation at the institutional level it has so far fallen flat.
On the positive side, when researching investment opportunities in stocks or ETFs, it can be helpful to look at ESG ratings because high ESG ratings often do correlate with strong performance, as is the case with the likes of Microsoft and Tesla.
