Featured Articles

ESG Investing - Approach with Caution

Note: This Featured Article has been compiled to provide readers with a better understanding of an area of growing significance in investment markets. As we are not experts on ESG, some of the information provided below is from other reliable sources while we also introduce some of our own views and opinions.

Summary

One of the biggest buzz phrases in the investment industry in recent years has been ESG (Environmental, Social and Governance) - be it in company presentations, fund manager discussions, investment forums, podcasts etc.

Many investment firms and companies are rightfully placing greater importance on ESG matters than before - driven by scrutiny from investors who are now emphasising these core issues and from Governments who have set out clear targets to tackle these problems, most notably climate change. And the CV-19 pandemic has put a further spotlight on the need to improve matters such as income inequality, diversity and climate change.

However, ESG investing is not without its difficulties and the fact that the majority of investment capital in ESG is flowing towards passive vehicles presents a number of challenges - including the lack of standardisation in terms of what constitutes ESG and the need for better quality data to improve ESG rating scores, along with ongoing problems with 'Greenwashing'[1].

Our message to date has been one of caution when approaching ESG investing by investors. In our view, an active fund manager who has experience in the space and is implementing a strategy that is in line with what can be deemed ESG principles is likely the best approach (at present). The difficulty, however, is sifting through the plethora of ESG-labelled funds to find the genuine candidates.

Introduction

What was once seen as a niche area in investing, ESG factors can no longer be ignored by investors. Like other current themes elsewhere in life (think technology, demography, healthier eating trends) ESG is becoming a disruptive force and is of increasing importance for investors as society rightfully places greater value on these matters. A recent study by Morgan Stanley indicated that 90% of millennial investors wanted their investments to closely reflect the values they hold.

However, many people may not know that ESG investing (or socially responsible investing) has been around since the 1970s when Pax World, a US-based sustainable investment firm, launched the first-ever sustainable mutual fund with the aim of avoiding investing in companies that had any involvement in the Vietnam War.

Since then, we have seen the launch of the US Sustainable Investing Forum in 1984 while the first capitalisation-weighted index built to track sustainable investments was launched in 1990. By 1994, there were 26 sustainable funds worldwide with $1.9 billion of assets. In addition, the UN's Principles for Responsible Investment was launched in 2006 to further encourage sustainable investing.

The 17 UN Sustainable Development Goals (SDGs) were set up in 2015 and continue to play a vital role in driving change. However, the latest focus on ESG has in no doubt been driven by the 'E' as the issue of climate change has become increasingly prioritised with policy and regulatory intervention growing rapidly and forcing change. Following the Paris Agreement in 2015, governments around the world set clear targets to make the world a more sustainable place - with a focus on reducing carbon emissions and increasing renewable energy sources and use. 

Consequently, there has been a clear focus on this subject in the investment industry in recent years. We regularly attend conferences and meet with fund managers and the topic of ESG is often the focal point - both from the fund managers themselves and investors. Publicly traded companies have also responded to pressure from investors with many dedicating sections of Annual Reports to ESG or sustainability reports which have since evolved into standalone reports.

In turn, the heightened focus has led to an acceleration in fund flows towards this theme - with investors pouring record sums of money into funds that are focused or at least claim to be focused on sustainability.

According to Morningstar, the US-based investment research company, funds with ESG principles had net inflows of $51 billion in 2020 which were more than double the total for 2019 and nearly 10 times more than in 2018.

ESG Fund FlowsAnd investors' appetite has continued into 2021 with the U.S. sustainable fund landscape seeing nearly $21.5 billion in net inflows in the first quarter of 2021, higher than the previous $20.5 billion record for a quarter seen in the last quarter of 2020.

However, the majority of these fund flows are towards passive investment vehicles which, in our view, poses a number of challenges. During the first quarter of 2021, passive funds claimed nearly $15 billion, or 70% of all U.S. sustainable flows which is in line with the circa 70% seen throughout 2020.

Core Issues with Passive ESG Investing

The topic of ESG is highly subjective in terms of what exactly constitutes ESG and there is a need for clear standards as to how one scores companies on ESG criteria. It is a broad subject that can take many definitions with different types of approaches (positive screening, negative screening, impactful investing, thematic investing etc). Investors may be looking for different outcomes from their investments and may be driven by differing views or areas of emphasis within ESG.

For example, is an investor more concerned about not investing in companies that are causing harm to the environment or is he or she actively looking for a company that is at the forefront of change? Is one trying to invest in companies that are directly tackling problems of climate change or companies that are making positive changes internally to reduce carbon emissions? Another investor may be more concerned about how a company treats its staff, the level of gender diversity among its employees or how it sources its products?

Passive investing comes in the form of exchange-traded funds (ETFs) or index funds that track a relatable index. Indices are developed using tick the box exercises, screening, scoring, or grading of companies which are provided by ESG rating agencies. These rating agencies take different factors into account when analysing ESG performance so there is a clear lack of standardisation at present.

As the process remains in its early stages there is also a lack of quality data and there is only a 32% correlation between ESG scoring of two of the top vendors of ESG data. Data provided on companies is also self-reported and unaudited which questions its reliability - allowing companies to cherry-pick the data and information they present to potentially artificially inflate their ESG score.

And this ties into another issue that is currently rampant in ESG investing: 'Greenwashing'. Given the unprecedented rise in fund flows into the space, asset managers have rushed to launch new products and while many funds are genuinely investing on the basis of sound ESG principles, there are far too many examples of funds marketing themselves as green-friendly in an effort to increase the fund's inflows - and a simple look at their top holdings would call into question their ESG credentials.

For example, just last week Legal & General Investment Management was accused of greenwashing by the CIO of SCM Direct, a UK wealth management firm - citing its ESG China CNY Bond ETF of not only investing in a country where its government falls short of the UN Global corporate sustainability principles but also the fact that it holds bonds from the same four issuers found in a non-ESG China Government Bond fund but just tilts the portfolio on ESG scores.

Research by Common Wealth also found that a third of climate-related funds sold in the UK are invested in oil and gas companies, most notably an ESG ETF at Lyxor holding ExxonMobil, one of the largest of the world's Big Oil companies.

Whether these examples stem from companies purposely putting ESG labels on funds to drive flows or are the result of poorly developed ESG scoring is debatable. Either way, however, it no doubt questions the reliability of these funds and makes it difficult for investors to properly address a growing desire for genuine sustainably driven funds.  

Finally, another concern we have with passive ESG investing (and passive investing in general) is the fact that there is no consideration for valuations. When an index fund or ETF receives inflows, the fund essentially has no choice but to invest in stocks based on their index allocation at that moment in time, without any consideration of company fundamentals or valuations.

Price-to-sales ratioWhen fund inflows are growing significantly as highlighted previously, these flows lead to overcrowding and can push valuations to unsustainable levels.

For example, the chart on the right is the price-to-sales ratio for the MSCI Global Alternative Energy Index, an index of companies that derive 50% or more of their revenues from products and services in Alternative energy i.e. not fossil fuels.

The price-to-sales ratio for the index accelerated to a high of 4.2 times at the beginning of 2021 driven by an increasing shift of investment capital towards sustainable investments. And despite falling back over the last six months, the ratio still stands at 3.2 times - in line with the current price-to-sales ratio for the S&P 500 Index. As we have highlighted on several occasions, valuations in US equities are at historical extremes and the current ratio is some 40% higher than the previous peak of 2.3 times during the dot-com bubble in late 1999. 

How GillenMarkets Approaches the Topic of ESG Investing

Reflecting our concerns, GillenMarkets has always conveyed a message of caution when approaching ESG investing. At present, we do not believe using passive investment vehicles is an appropriate approach for investors looking for suitable ESG-related investment products. In our view, it is important to put in the groundwork and understand what you are investing in before making a commitment to an ESG investment, even when looking at active funds.

The goal for GillenMarkets when looking for ESG investments is to find fund managers who have considerable experience in the space, have a clear understanding of ESG principles and apply a consistent approach that we understand and believe reflects genuine ESG principles. However, one must understand that these approaches or views are also subjective in nature.

As an example, we introduced the Schroders Global Energy Transition Fund for subscribers and clients last year, and we also have a 3% holding in our own in-house fund, the GM Fund. The manager has an established background in the energy sector and looks to invest in a concentrated portfolio of 30-50 fossil-fuel-free high-quality companies which are at the forefront of the current long-term transition to clean energy but uses the active mandate to ensure the fund is not overexposed to highly valued areas of the sector. The fund invests across the entire energy value supply chain - finding opportunities in companies such as wind turbine and solar panel manufacturers, producers of energy storage systems and developers of energy transmission and distribution.

We also cover the Mobius Investment Trust in the members' area of our website, a London-listed investment trust chaired by the highly respected Mark Mobius and managed by Carlos Hardenberg. The trust invests in mid-cap emerging market companies with ESG principles at the core of its DNA and investment process. Having read a book by the managers on ESG investing in emerging markets (Invest for Good) and attended a presentation by the management team, it is clear that the managers have considerable experience in the space and are likely leading the way in ESG investing in emerging markets.  

Recently, we have been exploring the possibility of introducing an impact fund that is focused on generating a positive impact by investing in companies that have the potential to address the world's major social and environmental challenges - contributing solutions towards achieving the UN's 17 Sustainable Development Goals.

Overall, what is clear to us in our research to date is that although the ESG investing space faces teething problems, there are funds out there adopting what can be deemed proper ESG principles and are genuinely trying to have a positive impact by driving changes. Our role in providing both wealth management services to our clients and an investment newsletter to subscribers is to do the heavy lifting and provide suitable options and solutions in this area of growing significance.

 

Jonathan Yates

Research Analyst, GillenMarkets

9th August 2021

 


[1]the process of providing false or misleading information about how products are more environmentally sound and is an unsubstantiated claim to deceive consumers into believing that its products are environmentally friendly.