ESG stands for Environmental, Social, and Governance. It represents the three key factors used to measure the sustainability and ethical impact of an investment in a business or a company. In theory, socially responsible investors will evaluate companies using ESG criteria to screen investments. ESG is a praiseworthy investing approach. It is also one in need of refinement or, at least, more realistic marketing.
ESG has been marketed as a panacea. Longstanding social, environmental, and governance shortcomings will be solved; companies adopting ESG standards will be less risky and more successful; and investors will earn higher returns. Not unlike “certified” organic products in the US, the ESG reality differs greatly from the sale pitch. Consider these ESG myths:
- Myth 1: ESG Investments Will Inevitably Outperform: There are numerous, now dated, studies supporting the belief that ESG based portfolios will outperform non-ESP portfolios. The reality is less clear. How do these studies explain the impact of the recent stock market crash on the stock prices of ESG adopting companies (predominantly tech firms) as compared to its impact on the stock prices of fossil fuel companies? And what about net investor returns? Average annual fees for sustainable funds are almost fifty percent higher than those of traditional funds. As Cliff Asness, a hedge fund manager, wrote a few years ago, investors in a portfolio that shuns “sinful stocks” should not expect to do better than those who have no such restrictions.
- Myth 2: ESP Adopting Companies Will be Less Risky and Perform Better: According to this myth, it has been found that businesses that adopt ESG standards tend to be less risky and consequently more likely to be successful in their long-term commercial aims. This is a classic, chicken vs egg debate. Do successful companies embrace ESG or does ESG somehow make firms more successful? Evidence supports the former, not the latter.
- Myth 3: ESG Data Can Be Measured Consistently: There are over 160 ESG ratings companies worldwide. The International Organization of Securities Commissions (IOSCO) says that there is little clarity on what ESG ratings firms intend to measure and what their methodologies are. In fact, companies can receive divergent ESG ratings.
- Myth 4: ESG Companies Are More Conscientious: In May 2022 a joint study published by two professors, one from the London School of Economics and the other from Columbia Business School, analyzed US mutual fund performance from 2010-2018. It found that companies in ESG portfolios violated labor laws, paid more fines and had higher carbon emissions than those in non-ESG portfolios sold by the same investment firms.
These and other ESG marketing myths have raised concerns about ESG investing. I still believe the concept has great merit, particularly if one takes a long-term perspective. For now, however, ESG is in dire need of better G.
Mr. Dragone has spent the past twenty years as an acting/consulting CFO for a number of start-ups in a wide range of industries. Peter’s prior experience is that of a serial entrepreneur, managing various start-up and turnaround projects. He was a co-founder of Keurig.