Many of us are now familiar with shopping for organic food, but there used to be a time when it was easy to be confused by the many organic labels and certifications used.
We gradually learnt the difference between ‘non-GMO’, ‘natural’, ‘organic’ and ‘100 per cent organic’ products, so that as consumers we would not be misled.
Today, investors looking to invest in ESG (environmental, social and good corporate governance) products are in a similar situation. As interest in sustainable investing grows and more products are launched, concerns about ESG ‘greenwashing’ - the practice of including misleading claims on ESG investments, are also growing.
What is ESG washing?
It is the practice where the investment manager’s claims of ESG integration are exaggerated or misleading. Examples include environment funds holding coal companies that do not have a clear transition plan or a fund manager not having an engagement strategy; ESG funds investing in companies in controversial industries such as tobacco and nuclear weapons; or where the integration of ESG factors is optional.
Research shows that when used well, ESG data can enable better investment decisions. In a study comparing over 10,000 funds between 2004 – 2018, it was found that sustainable funds provided returns in line with comparable traditional funds while reducing downside risk. It is increasingly costly to ignore ESG risks, as shown in a December 2019 report which highlights that ESG controversies wiped USD500bn off the value of US companies over the last three years. Our recent Global Market Outlook Report highlights that with the COVID-19 impact on markets, early evidence has shown some resilience in terms of ESG strategies, which look at companies with strong environmental, social and good corporate governance practices.
"As interest in sustainable investing grows and more products are launched, concerns about ‘greenwashing’ are also growing."
As you consider sustainable investments, here are five questions you can ask your financial advisor to evaluate the credibility of the ESG funds presented:
1. Are certain sectors excluded from the ESG fund and is there sound thinking behind exclusions?
Discussions around exclusions are often personal and investors have differing opinions. Some investors prefer that their ESG funds not include alcohol, tobacco, fossil fuel and weapons, while others may be comfortable with various of those.
However, given the complex nature of supply chains, the key is to know where to draw the line with respect to the nature of business involvement and the companies’ materiality thresholds. For example, we may exclude tobacco manufacturers from the ESG funds selected, but not exclude supermarkets and stores distributing cigarettes if the proportion of revenue from cigarettes is less than five per cent of their overall revenues.
As an investor, you should decide on what is important to you.
2. What is the fund’s ESG strategy?
ESG strategies range from thematic ones focused on, for example, the environment, water, or sustainable foods, to best-in-class integration, where ESG factors are considered alongside financial metrics in the analysis of a company.
For thematic strategies, it is important to understand the fund manager’s intent. For example, some managers of environmental funds select companies that contribute towards innovation and reduction of carbon emissions while others may select based on companies’ focus on their carbon footprint.
Best-in-class integration funds should have a strong understanding of how ESG factors affect their portfolio and that not all metrics are of equal importance. For instance, environmental factors are more important in the mining sector from a risk management perspective, than they are for a bank in financial services, so the weighting of these factors should differ. How a manager determines a fund’s ESG rating should also be considered - are they relying solely on ESG score by rating agencies?
3. How experienced is the team?
The experience and expertise of the ESG investment team is important. Some fund houses have a large central ESG team while others have portfolio managers and analysts with strong ESG knowledge. Leaders in the space have a good balance of both.
4. How is ESG being integrated?
To better understand how ESG factors are integrated, portfolio managers should walk you through examples of companies being selected to be included in the fund, of positions being exited, and how ESG factors are considered at each stage of the process.
Leaders in the space have a clear articulation of this, and a systematic, institutionalised way of embedding ESG through to analysis and evaluation. ESG research should contribute significantly towards the eventual decision of including or excluding a company and not just exist as an optional reference point.
Another huge consideration is active ownership/stewardship activities of the fund houses, specifically how involved they are with proxy voting and engagement with companies.
5. How are you measuring impact?
For ESG funds marketing themselves as impact funds, ask for quantitative and qualitative data on how they are measuring social and/or environmental impact. Meaningful quantification of impact is not always easy, especially for public companies, since their impact may not be as direct as investments made in private markets. It is important that fund managers are honest about the challenges faced, and the steps being taken to plug data gaps and provide investors with meaningful reporting.
In the long run, regulation, standardisation and initiatives to better define sustainability like the European Union’s taxonomy, or to improve data on companies’ climate-transition risks, like the global Task Force on Climate-Related Financial Disclosures, should help mitigate ESG washing.
For investors exploring ESG investments and for those who are concerned about ESG washing, asking some of these questions will help you better understand the funds presented to you. As Benjamin Franklin wisely said, “An investment in knowledge pays the best interest".
This article has been provided for general information purposes only, it does not take into account the specific investment objectives or financial situation of any particular person or class of persons and it has not been prepared as investment advice for any such person(s). Further details can be found at the disclaimers here.
A version of this article originally appeared in The Business Times, Singapore on 28 March 2020.