ESG ratings are subjective and difficult to measure, so rating agencies can point to any arbitrary measure as a reason for ESG compliance or non-compliance.
ESG has become a leading topic in the investment industry, with fund managers and investment analysts spending a lot of time getting to grips with it.
Fund managers use words like “impact investing” and “socially responsible investing” when referring to ESG, convincing investors that their funds are used to drive positive change.
The belief is that investing in companies with strong ESG credentials creates long-term value as they are run more sustainably.
Investors are sold the narrative that putting their money in ESG funds supports strong environmental initiatives, ethical decisions, and sustainable business practices.
However, the ESG movement has come under scrutiny as many feel it is misleading and ineffective.
A key issue is widespread confusion around the meaning of ESG and how companies are rated.
ESG ratings are highly subjective and difficult to measure, which enables agencies to point to arbitrary measures as a reason for ESG compliance or non-compliance.
Tesla’s recent removal from the S&P 500 ESG Index, which seemed non-sensical to many investors, is a good example.
A research paper by Florian Berg, Julian F Kölbel, and Roberto Rigobon – Aggregate Confusion: The Divergence of ESG Ratings – confirmed the subjectiveness and inconsistency of ESG ratings.
They assessed six rating agencies and found that the ratings varied substantially from each other. The findings were based on three main sources of rating agency divergence:
- Scope divergence – differences in the attributes that agencies choose to base their ESG ratings on.
- Measurement divergence – differences in the variables that agencies use to measure the same attributes.
- Weight divergence – differing opinions on the importance of certain attributes indicated in the weighting of the attribute to the final ESG score.
Despite these inconsistencies, decisions continue to be based on these ratings.
For instance, more than 3,000 investment firms representing more than $100 trillion have committed themselves to integrating ESG data into their investment processes.
These integrations are mainly based on ESG ratings.
The inconsistencies in ratings have caused investors to feel misled by asset managers that made wild promises on the ESG impact of investment products. It is a practice known as “greenwashing.”
This misleading practice has forced many asset managers to downgrade their clients’ investment products to lower ESG ratings. It resulted in over $100 billion in reclassifications.
For example, Deutsche Bank’s asset management units were recently raided and are currently being sued for the same reasons – exuberant and misleading ESG marketing practices.
There have also been other accusations made against ESG products.
Investors have been investing in these products to align their investments with their values. However, many noted that these funds hold almost identical positions to the non-ESG alternative.
ESG funds also charge much higher fees as asset managers need to conduct regular screenings – based on ESG ratings – to keep the product “ESG friendly.”
As a result, many investors are left with an identical product to the non-ESG alternative. However, because it is more expensive, it gives lower returns.
To illustrate this point, Daily Investor compared an ESG fund and a non-ESG fund to the S&P 500 index with a $100 investment since 2005.
- MSCI USA ESG Select ETF
- iShares Core S&P500 ETF
- S&P500 index
As expected, the iShares Core S&P 500 ETF almost precisely tracks the S&P 500 index. What is more interesting is that the ESG fund also tracked the S&P 500 index closely.
However, the ESG fund underperformed the S&P 500 tracker fund and S&P 500 index. It delivered only $445 compared to the iShares Core S&P 500 ETF’s $475 and S&P 500’s $472.
Based on both ETF fund factsheets, the Core S&P 500 and ESG fund have Apple, Microsoft, Tesla, and Alphabet as their top holdings.
The iShares Core S&P 500 ETF has an annual total expense ratio of 0.03%, whereas the MSCI USA ESG Select ETF charges eight times more with a total expense ratio of 0.25%.