The ESG Moment of Truth
The ESG Moment of Truth
MARCH 2022 | By Igor Tsukerman - Chief Investment Officer, Eureka Wealth Solutions Chief Investment Officer, Eureka Wealth Solutions
Impact investing is not a new term. In fact, it’s been around for decades. Over the past several years, ushered in part by the pandemic, climate change fight, and energy transition process, the ideas of impact investing have finally gone mainstream. ESG, which stands for Environmental, Social and Governance, in particular, has drawn a lot of attention from investors, under the slogan of doing good while making a profit.
Many institutions and asset managers have rushed to offer investors ESG investment products. But ESG investing is still not well-defined and is often misunderstood by investors and even their financial advisors. What the investor’s assumption about the fund may be does not often match what the asset manager had in mind. Many potential conflicts of value exist, which are worthy of a separate discussion. Now, after the recent Russian invasion of Ukraine, new uncomfortable questions have been raised.
A recent Bloomberg article shines the spotlight on some of them. Why do ESG-labeled funds hold oil and gas companies? What about Russian state-owned or assisted businesses? Conversely, while weapons companies are not traditionally part of the ESG concept, should defensive weapons used by democracies defending against autocratic invasions get a different treatment? Especially considering that the attacking army has a huge and growing list of evidence of committing war crimes. What about non-lethal defense companies providing logistics, supplies and surveillance?
And if Ukraine is unable to provide its main export, wheat, should we consider Brazil’s additional exports that come at the expense of deforestation of the Amazon? The author’s conclusion in the article is that many ESG funds including some of the most popular ones do not adhere to principles of social responsibility, and he questions whether in this “ESG moment of truth” ESG scores really provide “a general measure of corporate goodness”.
A lot of these questions go to the heart of the problem: the definition and methodology of the movement. Wikipedia defines impact investments as those made into companies, organizations, and funds with the intention to generate a measurable, beneficial social or environmental impact alongside a financial return. Other sources give a similarly vague definition, leaving investors to decide for themselves what a “measurable impact” means to them. Socially Responsible Investing (SRI) is defined as integrating social and environmental factors within investment analysis to avoid investing in companies that have negative impact on the environment and/or society. This is one of the key types of impact investing, and it’s also known as values-based or ethical investing. The other, ESG, merely suggests the use of E, S and G metrics to screen potential investments.
While SRI and ESG definitions may sound alike, the practical approach for portfolio construction under these two concepts has been different. Opposite, in fact. SRI is typically built with a negative screen while ESG portfolios are done through a positive screen, as illustrated below.
In many ways, SRI investing has been easier to understand. Examples of SRI ETFs (and these are not recommendations to buy or sell) include WisdomTree China ex-State-Owned Enterprises Fund (CSXE), which avoids Chinese companies with a government stake of 20% or more. Another example is the Change Finance U.S. Large Cap Fossil Fuel Free ETF (CHGX), which takes 1,000 largest US companies and screens out fossil fuels. ESG, on the other hand, typically picks a theme to create a screen. For example, iShares Global Clean Energy ETF (ICLN) or SPDR SSGA Gender Diversity Index ETF (SHE) seem self-explanatory, although investors would still be prudent to check the exact methodology of each fund in the prospectus.
We’ve created the graph above to help our clients better understand where different styles of investing lie with respect to the balance of doing good vs. making a profit. The confusion often lies with the broad funds that often mix concepts such as the fund used as a quick case study in the aforementioned Bloomberg article. The iShares ESG Aware MSCI USA ETF (ESGU) is the largest fund billed as ESG, with nearly $23B AUM. As its prospectus suggests, it tracks an MSCI index with “positive ESG characteristics”. The fund does report that it screens out businesses involved in thermal coal, oil sands, tobacco, civilian firearms, controversial and nuclear weapons (and thank God for that!) That is very SRI of it.
However, you’d have to go to the index provider to try to understand how those specific ESG scores are calculated and used. Essentially, they’re being used as a factor, a popular concept from several years ago that was advertised as the best of active and passive investing worlds. Similar to momentum, volatility, market size, quality or dividend yield, the ESG scores are used to slightly alter the weights in the portfolio. That explains why this giant fund holds 3.1% of its portfolio in the traditional Energy sector, comparable to that sector’s share in the S&P 500 Index. And no, those do not include alternative energy, in case you’re wondering. That’s because alternatives – not oil, gas, or coal – are not currently classified by S&P as “energy”. Many solar companies are semiconductors and are part of Technology sector, the solar installers are Industrials, and alternative power generators are Utilities. So, while the fund did screen out some bad actors, the majority of fossil fuels, as well as conventional weapons and other traditional “sin” industries of alcohol and gambling, are certainly in it. Blackrock may not be guilty of greenwashing – another concept for another discussion – because they did disclose all this information. However, an investor or advisor thinking their investments in the fund align with their values based on the fund’s name without looking under the hood will only have themselves to blame.
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