Investing in sustainable funds has never been more accessible but has the increase in low-cost environmental, social & governance (ESG) trackers diluted the message of sustainable investing?
Companies are often given sustainability scores from ratings providers which often have little correlation to each other. This means it can be hard to decipher which passive funds suit an individual investor’s ESG investment goals.
The European Securities and Markets Authority (ESMA) recently highlighted some key issues and challenges around ESG ratings, responding to the growth in demand of these products and fears over their reliability.
The market for ESG ratings and other assessment tools is currently unregulated and unsupervised, said the ESMA report.
“When combined with increasing regulatory demands for consideration of ESG information, there are increased risks of greenwashing, capital misallocation and products mis-selling,” it noted.
It also said there should be a common definition of ESG ratings that covers the broad spectrum of possible ESG assessments currently on offer.
The issue lies in the fact that ESG indicators are the result of a series of judgements and analyses that can vary significantly and lead to very different conclusions. The key providers of the ESG ratings are predominantly from MSCI, Sustainalytics and Thomson Reuters.
In arriving at an ESG score, each data provider compiles its sustainability analysis into a single measure, which can understandably cause disparities across the universe of different providers.
As such, Trustnet, in the second part of its series looking at ESG and passive strategies, spoke to market experts about the difficulties of trying to reach an ESG consensus with conflicting ratings agency data.
“ESG ratings can oversimplify the purpose of investing sustainably,” said Rebecca Craddock-Taylor, director of sustainable investment at Gresham House. “Whether an investment is sustainable or not, is not a binary question, and is difficult to assess from a rating alone.”
The ratings classification often neglects smaller forward-thinking companies which do not meet the criteria, in favour of larger companies with more measurable metrics.
“Investors should also consider that a high ESG score does not necessarily mean the company is making larger contributions to our environments, societies, and economies,” Craddock-Taylor added.
Indeed, the process behind setting an ESG rating can often be complicated and vary quite considerably depending on the provider.
“A standardised approach to forming an ESG rating of a company could create uniformity and improve the understanding for investors,” said Craddock-Taylor. “However, companies could end up manipulating these by being very careful with what they disclose publicly and as a result ESG ratings would lose their value to investors.”
Another potential issue may lie in what’s included in index-tracking funds.
While an investor may be satisfied to see their portfolio more in line with ESG credentials – the reality under the bonnet can be quite different.
For instance, the methodology of the Dow Jones Sustainability Index (DJSI) takes the top-ranked companies from each industry and then selects the top 10 per cent based on sustainability scores for inclusion in the index.
“The DJSI includes companies like miners, British American Tobacco and Rolls-Royce, companies which may be best in their sector, but ones that sustainable or ethical investors may not want to be associated with,” said Mikkel Bates, regulatory manager at FE fundinfo.
Understandably, there is an option for investors who wish to limit their exposure to controversial industries and Dow Jones offer indices which exclude criteria such as firearms, alcohol, tobacco, gambling, and adult entertainment.
Whether the exclusion of those particular, so-called “sin” stocks is enough depends on the individual sensibilities of the investor and the level of compromise that is willing to be accepted.
“If you don’t invest in alcohol or tobacco – do you then invest in supermarkets?” asked Bates. “Then it becomes a question of how much that company makes in revenue through the sale of alcohol and tobacco.
“It’s the most convoluted subject this industry has ever had to grapple with because it’s not binary, or cut and dried – it’s about what the millions of investors want from their investment.”
A standardised ESG ratings approach may help investors navigate these more nuanced areas, but as Bates pointed out, there is currently too great a disparity between providers.
“The oft-quoted correlation between different rating agencies is 0.16,” he said. “In other words, there is no correlation at all.”
Correlation between scores of major ratings agencies
Source: Schroders
Because of the nature of passive funds, they are limited to the index of which they track. However, as Matthew Wiles of Aberdeen Standard Investments outlined, the issues occur in active funds too.
“As with all passive investments there is certainly an element of standardisation and investors must be comfortable with this before deciding to allocate capital,” said Wiles, co-manager of the My Folio Sustainable fund range at Aberdeen Standard Investments.
“Different data providers and ESG ratings firms utilise different methodologies and this can and does lead to different outcomes, however, this is also true of active managers and will depend on interpretation and subsequent justification.”
He finished: “Passive ESG investing is not necessarily a means of simplification. The ESG ratings agencies provide some of the most rigorous analysis, it is simply that the application of the information is carried out in a systematic, rules-based fashion.”