ESG Investing Is Deeply Flawed. Here Are 3 Ways to Improve It.

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Responsible investing, and more specifically, environmental investing, is becoming increasingly popular in Canada. This has contributed to the recent growth in ESG investing, which stands for Environment, Social and Governance, and the growing inventory of “green” or “clean” companies available on the stock market. 

The main problems I see with popular ESG funds are:

  • The fees are higher compared to more traditional strategies;
  • They are highly concentrated in a few stocks, where the investment theme is too specific;
  • The largest ESG funds very often invest in the same large companies as traditional index funds, but with higher fees;
  • ESG selection criteria are subjective, meaning that they vary from one individual to another due to personal opinions.

Now that I’ve shared the main risks for investors, there’s another, major problem. ESG investing is not necessarily achieving the goal of sustainability or social responsibility, even though some funds or companies claim it to be so, because the underlying securities may not meet the investor’s goals. Unfortunately, many of them are marketed using terms such as “best in class,” “sustainable” or “low carbon.” To say this is misleading would be an understatement. 

The ESG  industry lacks transparency and should make a better effort to indicate where the investor is actually investing their money. Here are 3 things that could be improved to make these funds more responsible. 

1. ESG funds should be selected based on transparent, strict criteria. 

The selection criteria for ESGs should be clearer and more stringent. Currently, there is no standardized approach to calculating or presenting the various ESG criteria. Investors can use a variety of approaches and data sources to create different products that will all ultimately carry the same ESG label. For the small investor, this is difficult to navigate, forcing them to blindly believe in any fund labelled “ESG.” How can you trust that these funds are, indeed, responsible, if there is no standardized approach – and no one enforcing it? 

2. ESG funds should focus on long-term performance.

Funds that focus on more innovative companies should focus on very, very long-term performance. Innovations take time to show results – a long time. It may take five, 10 or 20 years before we know whether a new technology will be successful. Banks and firms may try to convince investors that responsible investing can be as profitable, or even more profitable, than traditional strategies. But they only use short time periods as a comparison, which means there’s a greater chance that investors will abandon these products after a few years of poor performance. Transitioning to clean fuels in the energy market is a very long process, and most shareholders want short-term results. Very few people would be willing to invest their money and wait 10 years to see if it was worth it. On the other hand, that’s probably what it would take to contribute to real change.

3. ESG companies should be considered based on future commitments to sustainability – not the past. 

Selection criteria for ESGs are more often based on a company’s past, rather than on its willingness to improve in the future. Responsible funds do not act as capital allocators. One might think that their goal would be to reallocate money from less responsible industries/companies to more responsible industries/companies. Surprisingly, that’s not how they work. So far, ESG funds have barely divested money from the fossil fuel industry and reallocated it to cleaner energy companies. This is because ESG criteria favour companies for their low carbon footprint, rather than their ability to decarbonize industries or their social impact on communities that will suffer from the energy transition. In other words, if a company pollutes less through its business model – think of a large technology company like Google – it has a better chance of being included than a company that is trying to improve the transition from fossil fuels to clean energy. 

ESG criteria as they stand today are flawed. Their success proves that people are more sensitive when it comes to investing their money, but there is a long way to go to make these products real contributors to a better world.  Some forward-thinking investors have identified this problem and are coming up with their own investment models to address climate change – for example, the Mulliez family. However, for the average investor, industry-wide change for ESGs is long overdue. 

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Author

  • Maxime holds a Masters degree in Finance from the Université de Sherbrooke and is a CFA charterholder since 2019. He joined the Claret team in 2016 as a junior investment research analyst and was promoted to portfolio manager in 2019.

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