Have the merits of ESG investment been overstated?

Two respected industry insiders offer contrasting perspectives on a much-hyped market based on the notion that purpose and profit go hand in hand

How times change. A year ago, asset managers were trumpeting the qualities of environmental, social and governance (ESG) funds, as a slew of data showed that these had beaten their conventional equivalents over several periods. Today, they have toned down their message after months of disappointing performance; negative stories about firms exaggerating the benefits of ESG; and the emergence of influential and increasingly vocal sceptics.

It’s time to ask seasoned experts in the field with differing views on the merits of ESG investment why they’ve adopted such positions.

THE SCEPTIC: Tariq Fancy, founder of the Rumie Initiative and former chief investment officer for sustainable investing at BlackRock

An outspoken critic of the claims made on behalf of ESG funds, Fancy believes that their outperformance has been greatly exaggerated.

“There’s much sloppiness in how fund managers talk about performance – confusing correlation with causation, for example,” he says. “We all want to believe that better ESG data leads to better profits and performance. Climate activists also jump on it and say: ‘Look – green investing is better.’ But it’s mostly just marketing in my experience. Many of their claims turn out to be untrue when you look behind the scenes.”

Fancy highlights a recent study from the MIT Sloan School of Management showing that ESG ratings from different ratings agencies have a low correlation. This continuing lack of well-defined, widely agreed standards is problematic.

“Such variances fuel all kinds of confusion and make it easy for people with vested interests to selectively quote data that satisfies their argument,” Fancy says.

He also refers to the work of fellow sceptic Aswath Damodaran, professor of finance at New York University’s Stern School of Business, who has argued that “being good” won’t necessarily add value to a company. Indeed, in some cases it will actually be detrimental to the business.

Fancy has been particularly annoyed by the hype that came from several wealth managers about the performance of their ESG investments during the early phases of the Covid crisis. The main reason why they did so well over that period was that their portfolios happened to be heavy on tech stocks and light on fossil fuels, he argues. 

“The biggest nonsense about data and correlations arose when the pandemic started. These firms were saying: ‘ESG is outperforming in 2020-21.’ During the lockdowns, we couldn’t travel and were forced to rely on technology. So, if your fund was overweight Microsoft and underweight Exxon, say, its performance was bound to look good,” Fancy says.

We all want to believe that better ESG data leads to better profits and performance… But it’s mostly just marketing in my experience

The argument is that they cannot realistically claim or even imply that intrinsic ESG-related factors were behind that performance when other, more powerful, forces were at play.

Fancy says part of the problem is that large asset managers are strongly incentivised to claim ESG outperformance, as it enables them to tap into the public’s growing awareness of matters of corporate social and environmental responsibility. 

“Wall Street CEOs refuse to engage directly with anything I say on the subject, even when I ask them directly,” he adds. “It’s not in their interests to have that debate.”

Fancy accepts there are some “kernels of truth” in the idea that ESG factors can improve returns, but these need to be communicated in a far more nuanced way. 

“We have known for a while that good corporate governance is important to returns,” he says. “But the relative importance of the environmental and social elements is more industry-dependent. Environmental factors can affect returns more if you are a company trading in, say, green energy or electric vehicles. Also, if you hold physical assets, such as infrastructure or real estate, you should be mitigating climate risks already. But that is not how ESG is being trumpeted from the rooftops.”

Fancy’s key message for traders is that many ESG-related tools, data and standards are emerging that you can use to cut through exaggerated claims to find the true drivers of performance.

And his overriding message for fund managers? “Be honest about the limits to what ESG can do.”

THE BELIEVER: Mike Fox, head of UK sustainable investments at Royal London Asset Management

ESG is a tool that, alongside measures such as macro analysis and valuations, can support investment decisions and lead to better risk-adjusted returns, according to Fox.

“The best way to look at ESG outperformance is to examine the record of those funds versus that of their non-ESG peers over the longest periods possible – more than 10 years if you can,” he recommends. “This helps to shake out other cyclical factors, such as sector-led bubbles and crashes.”

Fox highlights the fact that numerous sustainable funds have posted top-quartile performance in the main Investment Association sectors – for instance, UK All Companies and Mixed Investment 40%-85% Shares. This was accurate over one, three, five and 10 years to 31 December 2021, according to Trustnet. Some sustainable funds topped these tables over several periods too.

“There have been many academic studies on outperformance, but this record is the ultimate test and proof that it works,” he says.

ESG factors will not deliver high performance in and of themselves, Fox stresses. As with any investment style, an individual manager’s execution can be good, average or poor. But ESG is a set of principles and a framework that, if implemented well, should improve a fund’s chances of good performance, he argues.

Like any investment style, ESG will have times when it outperforms and times when it underperforms

A whole host of ESG factors could affect returns, from the cost of maintaining stranded fossil-fuel assets such as oil wells to the reputational damage caused by treating workers poorly.

But little research establishing causal links rather than mere correlations yet exists. One notable study, by Newcastle University and Kuwait Business School in 2020, found a strong positive association between companies’ propensity to make voluntary disclosures about carbon emissions and their financial performance. Such reporting supported activities such as reducing waste, increasing productivity and opening market opportunities.

Fox acknowledges that causation element needs to be “unpicked” further. But he believes the argument that the recent performance of ESG funds has been affected more by the pandemic and the war in Ukraine than by ESG factors is misdirected. 

“Like any investment style, ESG will have times when it outperforms and times when it underperforms. We underperformed in 2008 and 2009, for instance. That didn’t change our methods, but it did make us cautious about our claims,” Fox says. “Funds investing in ESG tend to be in well-established large caps. ESG flows haven’t moved their prices yet. Things such as prices overextending during the pandemic or falling now won’t change the world’s structure in five or 10 years’ time in terms of carbon intensity. We don’t know the exact impact that climate change will have on corporate performance, but it won’t be good. So it’s best to be cautious about this.”

Fox’s advice for traders wanting to get the best performance from ESG investments is to gain a detailed understanding of the areas they’re targeting and to be prepared to “own” their strategy through economic cycles. 

“Because you’re investing in industries that will become more relevant [such as green energy] and moving out of those that will become less relevant [such as fossil fuels], this will give a better risk-adjusted performance over the long term,” he says.