An inconvenient truth about ESG investing

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Investing in sustainable funds that prioritize ESG objectives is believed to help improve the environmental and social sustainability of business practices. Unfortunately, in-depth analysis suggests that not only does this not make much of a difference to companies’ actual ESG performance, but it can actually direct capital to underperforming companies.

As of December 2021, assets under management of global publicly traded “sustainable” funds that publicly set environmental, social and governance (ESG) investment objectives were over $2.7 trillion; 81% were in European-based funds and 13% in US-based funds. In the fourth quarter of 2021 alone, $143 billion of new capital was invested in these ESG funds.

How did investors fare? Not so well, it seems.

For starters, ESG funds are certainly underperforming financially. In a recent Journal of Finance article, researchers at the University of Chicago analyzed the Morningstar Sustainability Ratings of more than 20,000 mutual funds representing more than $8 trillion in investor savings. Although funds with higher sustainability ratings certainly attracted more capital than lower-rated funds, none of the funds with high sustainability outperformed the lower-rated funds.

This result might be expected, and it is possible that investors are happy to sacrifice financial returns in exchange for better ESG performance. Unfortunately, ESG funds do not seem to offer better ESG performance either.

Researchers from Columbia University and the London School of Economics compared the ESG performance of US companies in 147 ESG fund portfolios with that of US companies in 2,428 non-ESG portfolios. They found that companies in ESG portfolios performed worse on compliance with labor and environmental rules. They also found that companies added to ESG portfolios do not subsequently improve compliance with labor or environmental regulations.

This is not an isolated finding. A recent article by the European Institute of Corporate Governance compared the ESG scores of companies invested in by 684 US institutional investors who have signed up to the United Nations Principles for Responsible Investment (PRI) and 6,481 institutional investors who have not. did not sign the PRI between 2013 and 2017. They did not detect any improvement in the ESG scores of the companies held by the funds that signed the PRI after their signature. In addition, the financial returns were lower and the risk higher for PRI signatories.

Why are ESG funds doing so poorly? Part of the explanation may simply be that an express focus on ESG is redundant: in competitive labor and product markets, business leaders trying to maximize long-term shareholder value should of their own free will pay attention to the interests of employees, customers, the community and the environment. On this basis, setting ESG targets can actually distort decision-making.

There is also evidence that companies are publicly embracing ESG as a cover for poor business performance. A recent paper by Ryan Flugum of the University of Northern Iowa and Matthew Souther of the University of South Carolina reported that when managers underperform earnings expectations (set by analysts following their company), they often spoke publicly about their focus on ESG. But when they beat earnings expectations, they made few, if any, public statements related to ESG. Consequently, sustainable fund managers who direct their investments to companies that publicly embrace ESG principles may overinvest in financially underperforming companies.

The conclusion to be drawn from this evidence seems quite clear: funds that invest in companies that publicly embrace ESG sacrifice financial returns without gaining much, if anything, in terms of promoting ESG interests.

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