New research reveals that Environmental, Social and Governance (ESG) investing may not be as ethical as it’s cracked up to be. The same research also suggests that ESG investing could ‘sacrifice financial returns’ without giving much in return.
Let’s take a closer look at the findings.
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What is ESG investing?
ESG investing refers to the practice of choosing stocks for ethical reasons. This is in contrast to traditional investing. That’s because when it comes to traditional investing, the main focus is usually on financial returns.
ESG stands for ‘Environmental, Social and Governance’. Let’s take a closer look at what each of these factors can cover.
- Environmental issues may relate to climate change matters, renewable energy usage and green technologies.
- Social issues may cover fair treatment of employees, ethical supply chains and levels of consumer protection.
- Governance issues may involve matters relating to business ethics or the level of transparency for shareholders.
Essentially, ESG investing might be considered the ‘go-to’ for investors wishing to use their wealth to benefit the greater good. Given recent media coverage on ESG issues, it’s an area that has experienced rapid growth over the past few years.
According to Columbia University, assets under management at global exchange-traded ‘sustainable’ funds with ESG investment objectives totalled more than $2.7 trillion (£2.2 trillion) as of December 2021. Of these funds, 81% were based in Europe, including the UK. Meanwhile, 13% were based in the United States.
The same data suggests $143 billion (£109 billion) of new capital flowed into ESG funds between September and December last year.
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What did the research reveal about the problems with ESG investing?
You may not be surprised to learn that ESG investing can deliver lower returns than traditional investing. After all, companies that have strong ESG values are less likely to prioritise financial returns – or so you might think.
According to Sanjai Bhagat, Professor of Finance at the University of Colorado, ESG investing does typically deliver sub-standard returns. He points to a University of Chicago research piece looking at sustainability ratings of 20,000 mutual funds. The research highlighted that the top-rated ESG funds typically attracted more capital than funds with low ESG ratings. However, none of them beat the financial returns of the lowest-rated funds.
Perhaps more striking was research by Bhagat’s own university that suggested some ESG funds could give the wrong impression regrading their ethical credentials. For example, when looking at the record of 147 US-based ESG fund portfolios and 2,428 non-ESG portfolios, companies listed in ESG portfolios were often found to have a “worse compliance record for both labour and environmental rules”.
ESG investing can ‘sacrifice financial returns’
Looking at the research, it could be concluded that ESG investing may not be as ethical as it seems.
In addition, we know that ESG funds typically underperform on a financial level compared to portfolios with lower ESG ratings. So, if ESG investing is seen as an unreliable indicator of the ethical values of individual companies, it poses the question of whether it’s a sector worth bothering with.
Professor Sanjai Bhagat echoes this summary. He explains: “The conclusion to be drawn from this evidence seems pretty clear: funds investing in companies that publicly embrace ESG sacrifice financial returns without gaining much, if anything, in terms of actually furthering ESG interests.”
Are you looking to invest? If you’re keen to invest, in ethical sectors or otherwise, take a look at The Motley Fool’s top-rated share dealing accounts. If you’re an investing newbie, also take a look at our investing basics guide which can help you avoid common investing mistakes.
Concerned about whether you’re investing ethically? If so, take a look at our article that explains how you can tell if an investment is ethical.
