Environmental, Social and Governance (ESG) investment funds, which reached $400 billion in assets under management in 2021, are meant to make investing in “good” companies easier. But do they deliver on the promise of promoting a greener, more just stock market?
Recent allegations against Germany’s Deutsche Bank claim the bank was greenwashing companies to sell its ESG funds at a premium. German investigators raided the bank’s Frankfurt offices in May and the scandal prompted the resignation of the bank’s CEO.
As ESG funds become popular globally and climate risk is a key investing criterion, the question of who rates companies’ ESG credentials and how they managed these funds is more important than ever, said Pekka Honkanen, an assistant professor of finance at the University of Georgia Terry College of Business.
Honkanen, who studies how company information and funds are transmitted and used by investors and regulators, explains ESG has become a valuable buzzword in the investing world. But not all ESG funds are created equally.
The U.S. Securities and Exchange Commission is expected to issue guidance on ESG criteria this year, but for now, there’s little oversight into how ESG funds are packaged or evaluated. Honkanen advised investors to talk to an expert before investing but answered basic questions about ESG funds and what investors should look out for to avoid greenwashing.
What is ESG investing and what are ESG funds?
ESG investing strategies evaluate companies on their environmental, social and governance impacts in addition to their ability to generate profits. The idea is to find investments that align with the investor’s values. So these could be funds that include the best companies in terms of E, S and G, or could include a company in each industry sector that’s best in terms of E, S and G. How funds define that is often subjective. All ESG investing is subjective. It is also not entirely clear how to balance the different aspects of the concept: the focus seems to be on the environmental aspect, with social and especially governance aspects receiving less attention. Some companies that score highly in governance may, for example, not satisfy an investor’s environmental and social criteria.
How common are ESG indexed funds in the U.S.? Is it in most people’s retirement portfolios?
The funds are massively popular, but the question is whether they’re popular because people want this, because fund issuers market them, or because you can feel good about your investments while still producing index returns. With regular broader market index funds or ETFs, the fees are five basis points or 5/100s of a percent — tiny. An ESG fund has a higher fee, maybe around 10 basis points. So it’s double but not much overall.
What company information does ESG funds consider when rating companies?
They look at carbon footprint, and there’s a huge focus on the investors’ side on environmental credentials. For the E part of the fund, there are scores from rating agencies, such as S&P, Moody’s, Morningstar, and so on. Similarly, you have scores and ratings for the S and G parts. This could be things such as parental leave or commitments to diversity. For governance, it takes into account transparency and independent boards. If we’re talking about listed U.S. companies, at least S&P 500 companies, they’re generally well governed because they’re required to have these systems in place. The fund issuers explain in their prospectus how they choose these. They may simply say they will follow the S&P 500 ESG Index, and then it would be up to Standard and Poor’s to define the criteria.
Does the United States have any regulations on these funds?
I think there’s more guidance coming out, and it should match up with guidance on other types of funds. If you say you are a bond fund, you have to invest in bonds. If you say you’re a small-cap fund, you have to invest in small caps; an international fund has to invest in international stocks. It should be the same if you’re an ESG fund. If you manage an ESG fund, it has to be ESG stocks. But what are those stocks? There is a push to be clearer about how these investments are chosen and what they are. Right now, if you look at the large ESG index funds, it’s Apple, Facebook, Nvidia — a lot of the big tech companies. But if you look at the S&P 500 index funds, it’s Apple, Nvidia, Facebook — a lot of the big tech companies. So the overlap is extremely high. What makes them ESG? Right now people looking at ESG funds are saying, “ESG has outperformed massively.” But it’s not because of ESG investments, it’s because they’re tech investments and tech stocks outperformed recently.
Who keeps track of the companies’ information and how is it verified?
There’s more and more a push for every company to publish their carbon footprint and reduction target. Whether it’s real or just posturing is one question. But if Exxon says they reduced their carbon footprint emission by this much, it is difficult for me to imagine they would fake that number too much — it would be found out. That applies to most large well-governed companies. If you have small caps with less strong governance structures, that could be different. If they are not auditing these claims yet, they will be in the future.
How big a risk is the greenwashing of company and fund information in the U.S.?
Companies with less established governance structures might gain something from greenwashing their information in the same way they would benefit from overstating their financial well-being. If you hide or underreport your emissions or overreport your diversity, you can only game the numbers for so long. Eventually, it will be revealed and be a problem. I’m guessing that would be securities fraud and there probably would be class-action lawsuits from investors. That type of fraud does happen, but not without serious repercussions.
What can investors do to make sure they’re investing in companies or funds that are fairly representing their ESG information?
The key point is to understand what you’re investing in, and that goes beyond just looking at the name of the fund. If it’s an ESG Fund based on the S&P 500 ESG listing and only costs you 10 basis points, that’s fine. But it will be very close to an S&P 500 Index fund. It may make you feel good, but you may not be doing anything. If you want to invest in an ESG way, there might be more narrow funds that make more sense. You must decide what is most important to you and find a fund that matches those goals. If environmental values are important to you, then a renewable energy fund may be the right thing, or maybe a fund investing in firms headed by minorities if the social aspect is more important. Just investing in a broad ESG mutual fund will most likely represent the stock market broadly. Remember, the more transparency the better.