“So, this fund has two completely different ratings,” I said to a few of my colleagues while on a Zoom call. We were several weeks into a research project comparing the ratings of various sustainable investment products.
“This fund is rated an A over here, while this other rating has it listed as D.” In this instance, an A is a better rating than a D. Clearly there was a disconnect between the different ratings.
I wondered how the same fund could have such vastly different ratings.
Well, as the saying goes, the devil is in the details.
For those unfamiliar with the term, sustainable investing refers to the practice of investing for the purpose of making a return while having a positive impact on the world and society at large.
Many factors can be considered when analyzing the sustainability of a particular investment—everything from carbon footprint to diversity of corporate boards to shareholder activism, just to name a few.
Although there is not one universal standard, there is a common framework from which sustainable investments are characterized. Environmental, Social, and Governance, or ESG, serve as the guiding principles for evaluating the sustainability impact of a particular investment. These principles can be applied to a variety of investment products, from mutual funds and exchange-traded funds to bonds to individual stocks of publicly traded companies.
Sustainable investing is hardly a new concept. A values-based approach to investing has roots in America dating back to the mid-1750s when the Religious Society of Friends prohibited its members from participating in the slave trade. Early founders of Methodism preached the basic tenets of financial stewardship in their sermons urging their congregations to abstain from business interests in the alcohol, tobacco, and gambling industries.
In the 1960s, protests against the Vietnam War successfully pressured university endowments to divest from defense contractors. In the 1980s, international divestment efforts helped bring attention and legislative action against apartheid in South Africa. Since 2011, fossil fuel divestment campaigns have resulted in dozens of government pension plans, foundations, university endowments, and religious organizations to drop fossil fuels altogether from their investment holdings.
Over time, values-based investing has made its mark on the world. Despite its growing prevalence, the dedicated ESG investment strategies of today are still relatively new. It wasn’t until 2015 that they really began to take hold. And given this increase in demand, Wall Street has been quick to capitalize on the opportunity.
Sustainable funds continued to break records in 2020. According to data from Morningstar, the number of sustainable funds available to U.S. investors grew by almost 100 last year. That number is up 30 percent from 2019. As of September 2020, the total number of sustainable funds around the globe stood at 3,774.
With that many sustainable funds in existence around the globe, one has to ask, “What’s in a name?”
Well, quite a few catchy phrases, to be exact. Sustainable, socially responsible, aware, fossil-fuel free, green, low-carbon, impact, and ESG are just a few of the labels used to denote sustainable investing strategies.
Despite the eco-friendly naming conventions, ESG funds differ greatly in methodology and construct. Some funds may only consider ESG criteria, whereas other funds may enact strict exclusionary methods, screening out entire industries based on socially responsible principles.
For example, a fund may screen out alcohol, tobacco, and firearms from its holdings while still investing in fossil fuels and deforestation. Another fund may screen out the fossil fuel industry while still investing in weapons manufacturing and for-profit prisons. Which one is more sustainable?
It’s rather subjective in that sense.
Such inconsistencies across the industry create potential pitfalls for investors. Absent a deeper analysis of the actual company or fund, investors could be left holding the industries or companies they were trying to avoid in the first place!
“Greenwashing” is a term that has gained relevancy in recent years with the rise in sustainable investing. Greenwashing refers to the misleading tactics used by a company to convince the public that their products and business practices are more environmentally sound or sustainable than they really are. One notable case occurred in 2015 when U.S. regulators discovered that Volkswagen had illegally tampered with their diesel engines in an effort to market them as “green.”
Although this is one of the most egregious instances by a company, the financial services industry isn’t immune from such tactics. With the sudden abundance of ESG funds available to U.S. investors, what’s in a name may in fact be just the name.
The ESG boom has revolutionized the business and investing landscape in a real way. ESG principles are reshaping business practices and portfolios. But absent a universal standard for disclosure requirements or ratings criteria, the concern over greenwashing remains a real one.
Such inconsistencies are likely to face additional scrutiny under the Biden administration. The newly appointed Chairmen
of the Securities and Exchange Commission has already launched a new Climate and ESG Task Force, which has taken aim at disclosure requirements by companies when it comes to environmental impact, diversity, and political spending.
Such changes could bring additional transparency and consistency into the ESG investing space. These efforts could also help standardize the methodologies used in rating the sustainability of ESG funds.
In the meantime, investors would be well-served to apply additional research and analysis when considering sustainable and ESG investment options.
Doing so can help ensure that what you’re buying is more than just a name.
Kevin Ihrke is a CERTIFIED FINANCIAL PLANNER™ professional and Team Member of Investment Insights, Inc. located at 508 N 2nd Street, Suite 203, Fairfield, IA 52556. Securities offered through, Cambridge Investment Research, Inc, a Broker/Dealer, Member FINRA/SIPC. Investment Advisor Representative, Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor.
Investment Insights, Inc & Cambridge are not affiliated. Comments and questions can be sent to kevin.ihrke@emailsri.com. These are the opinions of Kevin Ihrke and not necessarily those of Cambridge, are for informational purposes only, and should not be construed or acted upon as individualized investment advice. Investing involves risk. Depending on the types of investments, there may be varying degrees of risk. Investors should be prepared to bear loss, including total loss of principal. Past performance is no guarantee of future results.Indices mentioned are unmanaged and cannot be invested in directly.