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Trillions of investor dollars are flowing to businesses that, according to themselves and other sources, are following the best so-called environmental, social and corporate-governance practices. This creates a powerful incentive for firms and asset managers that own the stocks of such companies also to make claims about the ESG-worthiness of those shares. Indeed, it would be hard to find a company that doesn’t make such claims.
The result is that it can be hard for investors to make sense of it all. “There is just so much confusion in the marketplace right now” about ESG, says Vishal Hindocha, the London-based head of sustainability at MFS Investment Management.
The good news is there are robust and free information sources about ESG-worthiness available to individuals. Regulatory changes on the horizon may help as well. But for now, there are four main reasons why being an ESG investor remains a challenge.
ESG is about more than just avoiding fossil-fuel or tobacco stocks. Analysts at
Miller/Howard Investments in Kingston, N.Y., scrutinize numerous regulatory filings, looking at such things as diversity in upper management and a company’s goals for reducing greenhouse-gas emissions. The result may be a 50- to 60-page analysis that helps shape a recommendation about a single stock, says ESG Research Director Nicole Lee.
But the picture might still be incomplete because of disparities in disclosure. Manifest Climate Inc., a Toronto-based software provider that helps companies with climate-risk planning, concluded that nearly one-half of the disclosures it analyzed recently weren’t clear enough or specific enough to be useful for investors. Mr. Hindocha of MFS says that in a major ESG ratings database he is familiar with, less than 10% of companies reported on human-rights compliance in supply chains.
The Securities and Exchange Commission has been considering a strengthening of climate-disclosure requirements, but changes might be less onerous than originally planned. There always will be some subjectivity in comparing the ESG-worthiness of one stock versus another, says Hans Olsen, chief investment officer at Fiduciary Trust Co. in Boston. “Green is very gray,” he says.
Though ESG-focused portfolios do beat broad markets at times, they also can lag, depending on their composition, says Mr. Olsen. Because some funds exclude fossil-fuel companies, for example, that hurt their relative performance in recent years when energy stocks were surging, he says.
A tendency among some ESG funds and ETFs to favor growth companies has also been a hindrance of late. Morningstar ‘s US Sustainability Leaders Index last year fell 24.5%, about 5 percentage points more than the S&P 500. That was partly because it tilts toward growth stocks, a Morningstar analysis concluded. Growth funds fell out of favor last year when interest rates rose.
So-called darker-green approaches, such as pure clean-energy funds, often result in more concentrated portfolios, says Hortense Bioy, global director of sustainability research at Morningstar Inc. That makes such funds more suitable as smaller holdings that complement an investor’s main portfolio, rather than core components, she says. By definition, limiting investment options produces less diversification and can result in more volatility.
Such issues pose yet another dilemma, says Ms. Bioy of Morningstar. Should investors avoid stocks that score poorly on ESG or buy them in the hope of gaining leverage with management and encouraging change?
Crafting a portfolio in sync with someone’s ideals requires taking time to think through such questions before making any investment moves, says Ann Marie Etergino, an adviser at RBC Wealth Management who focuses on impact investing. To succeed in ESG, she says, “Investors have to really understand their own values and what they’re trying to achieve.”
The SEC’s so-called Names Rule requires a fund that claims to emphasize sustainability to put at least 80% of its assets into ESG-worthy securities. But this leaves open how the rest must be allocated, which might surprise people if they examine a fund’s holdings, says Michael Young, director of education for the nonprofit Forum for Sustainable and Responsible Investment. “You would think [portfolios] would be as accurate as possible, not just 80% accurate,” he says.
A case in point might be SPDR S&P 500 Fossil Fuel Reserves Free ETF (SPYX). A small portion of its $1.3 billion in assets is made up of shares in energy companies including Marathon Petroleum Corp. , Phillips 66 and Valero Energy Corp. , as well asBerkshire Hathaway Inc., which itself holds major positions in energy stocks.
State Street Corp.’s State Street Global Advisors, sponsor of the ETF, didn’t respond to requests for comment.
The SEC is seeking comments on possible changes to its Names Rule and has stated in a formal notice, “Fund names are often the first piece of information investors see, and they can have a significant impact on an investment decision.” Mr. Young and other ESG experts believe that the SEC will adopt revisions to the rule later this year. An SEC official declines to confirm that timing.
Why It’s So Hard to Be an ESG Investor
Supporting societal change through investing is one of the most popular themes in the financial world these days. But it is more challenging than many might realize.Trillions of investor dollars are flowing to businesses that, according to themselves and other sources, are following the best so-called environmental, social and corporate-governance practices. This creates a powerful incentive for firms and asset managers that own the stocks of such companies also to make claims about the ESG-worthiness of those shares. Indeed, it would be hard to find a company that doesn’t make such claims.
The result is that it can be hard for investors to make sense of it all. “There is just so much confusion in the marketplace right now” about ESG, says Vishal Hindocha, the London-based head of sustainability at MFS Investment Management.
The good news is there are robust and free information sources about ESG-worthiness available to individuals. Regulatory changes on the horizon may help as well. But for now, there are four main reasons why being an ESG investor remains a challenge.
1. Gauging greenness is complicated
ESG is about more than just avoiding fossil-fuel or tobacco stocks. Analysts at
Miller/Howard Investments in Kingston, N.Y., scrutinize numerous regulatory filings, looking at such things as diversity in upper management and a company’s goals for reducing greenhouse-gas emissions. The result may be a 50- to 60-page analysis that helps shape a recommendation about a single stock, says ESG Research Director Nicole Lee.
But the picture might still be incomplete because of disparities in disclosure. Manifest Climate Inc., a Toronto-based software provider that helps companies with climate-risk planning, concluded that nearly one-half of the disclosures it analyzed recently weren’t clear enough or specific enough to be useful for investors. Mr. Hindocha of MFS says that in a major ESG ratings database he is familiar with, less than 10% of companies reported on human-rights compliance in supply chains.
The Securities and Exchange Commission has been considering a strengthening of climate-disclosure requirements, but changes might be less onerous than originally planned. There always will be some subjectivity in comparing the ESG-worthiness of one stock versus another, says Hans Olsen, chief investment officer at Fiduciary Trust Co. in Boston. “Green is very gray,” he says.
2. A heavy ESG focus can pose investment risk
Though ESG-focused portfolios do beat broad markets at times, they also can lag, depending on their composition, says Mr. Olsen. Because some funds exclude fossil-fuel companies, for example, that hurt their relative performance in recent years when energy stocks were surging, he says.
A tendency among some ESG funds and ETFs to favor growth companies has also been a hindrance of late. Morningstar ‘s US Sustainability Leaders Index last year fell 24.5%, about 5 percentage points more than the S&P 500. That was partly because it tilts toward growth stocks, a Morningstar analysis concluded. Growth funds fell out of favor last year when interest rates rose.
So-called darker-green approaches, such as pure clean-energy funds, often result in more concentrated portfolios, says Hortense Bioy, global director of sustainability research at Morningstar Inc. That makes such funds more suitable as smaller holdings that complement an investor’s main portfolio, rather than core components, she says. By definition, limiting investment options produces less diversification and can result in more volatility.
3. Investors might be fuzzy about their own ideals
Few companies rate highly on all aspects of ESG, so an altruistic investor must set some priorities. Should climate change, for example, trump concerns about, say, a corporate board’s independence? Should the treatment of workers be a priority? In addition, altruism or social concerns might be a factor, but not the only factor, for many investors. But how big a factor? That’s something each investor will have to wrestle with.MORE ESG COVERAGE
- • The Intelligent Investor: ‘Green’ Funds Cost More Than You Think
- • Investors Are All for ESG. Except When Times Are Tough.
Such issues pose yet another dilemma, says Ms. Bioy of Morningstar. Should investors avoid stocks that score poorly on ESG or buy them in the hope of gaining leverage with management and encouraging change?
Crafting a portfolio in sync with someone’s ideals requires taking time to think through such questions before making any investment moves, says Ann Marie Etergino, an adviser at RBC Wealth Management who focuses on impact investing. To succeed in ESG, she says, “Investors have to really understand their own values and what they’re trying to achieve.”
4. Names might not tell the whole story
The SEC’s so-called Names Rule requires a fund that claims to emphasize sustainability to put at least 80% of its assets into ESG-worthy securities. But this leaves open how the rest must be allocated, which might surprise people if they examine a fund’s holdings, says Michael Young, director of education for the nonprofit Forum for Sustainable and Responsible Investment. “You would think [portfolios] would be as accurate as possible, not just 80% accurate,” he says.
A case in point might be SPDR S&P 500 Fossil Fuel Reserves Free ETF (SPYX). A small portion of its $1.3 billion in assets is made up of shares in energy companies including Marathon Petroleum Corp. , Phillips 66 and Valero Energy Corp. , as well asBerkshire Hathaway Inc., which itself holds major positions in energy stocks.
State Street Corp.’s State Street Global Advisors, sponsor of the ETF, didn’t respond to requests for comment.
The SEC is seeking comments on possible changes to its Names Rule and has stated in a formal notice, “Fund names are often the first piece of information investors see, and they can have a significant impact on an investment decision.” Mr. Young and other ESG experts believe that the SEC will adopt revisions to the rule later this year. An SEC official declines to confirm that timing.
Where to go online
Here are online resources that an investor could use to bone up on ESG (investments tied to environmental, social and corporate-governance issues) and see ratings of mutual funds or exchange-traded funds.- • Morningstar.com has an entire section on sustainable investing, with articles about trends, and has proprietary ESG ratings for funds as well. Access to some of its content requires a subscription.
- • Shareholder activist group As You Sow, based in Berkeley, Calif., operates a free online fund-screening tool. For example, says chief executive Andrew Behar, an investor concerned about global rainforests could check whether a fund owns shares of companies that might source materials from rainforests, such as palm oil, rubber or timber.
- • The nonprofit Forum for Sustainable and Responsible Investment, or SIF, offers a free online course about ESG basics. In about 30 minutes, someone who takes the course could learn enough to get started in sustainable investing by, for example, choosing ESG-centric funds for a 401(k) plan, says Michael Young, SIF’s director of education.
