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ESG Investing: A Change in Paradigm or Business As Usual?

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  • Dec 2, 2020

As far as acronyms go, ESG, or Environmental, Social, Governance (ESG), is a catchy one.

It has an appealing shtick in an era of peak climate change concern and Black Lives Matter (BLM) movements. It also holds rogue corporate firms, whose unchecked pursuit of profits generates considerable environmental and societal damage, to account.  

And it is a lucrative moniker.

At the beginning of this year, the CEO of Blackrock, the world’s biggest asset manager, called climate change, a key tenet of ESG principles, stated that climate change heralded a “fundamental reshaping of finance.”   Since then, ESG investing has been on a roll.

Assets in sustainable mutual funds and exchange-traded funds hit a record $1.2 trillion in the third quarter, up 19% from the previous quarter, according to research firm Morningstar. In the United States, $179 billion has already been allocated to ESG funds, up 12.5% from the last quarter.

But has all that money and corporate do-goodery actually moved the needle in terms of climate change or diversity? At least for the top ESG funds, it hasn’t. Instead, it has simply perpetuated the existing profit dynamic and replicated the movements of broader stock market indices.

ESG is Tech and Tech is ESG  

ESG funding rewards firms who conduct business ethically and in an environment-friendly manner. At the same time, the funds are supposed to generate profits for investors. Accommodating these twin objectives is a tricky task and causes problems.

I have touched on this topic earlier. Briefly, there are no standards for what constitutes an ESG strategy. Inclusion of companies within an ESG index depends on the fund manager’s definition of the term and seems to rest at the company’s discretion and interpretation of ESG initiatives.

And so, it should come as no surprise that companies from sectors that perform well in the stock market tend to find favor with ESG portfolio managers. Among the top three ESG funds by market capitalization, companies from the tech sector account for as much as a third of fund constituents.

Tech conglomerates, such as Microsoft Corp. and Apple Inc., are favorites. The problem is that these firms have trillion-dollar valuations on the back of successful business models that generate fat profits. In other words, they already have access to substantial funding from the markets. A vote of confidence regarding their environmental credentials simply adds to the pile of cash at their disposal. Other sectors popular with ESG funds in recent times are healthcare and pharmaceuticals, two sectors that have witnessed increased valuations in the year of the coronavirus.

One could argue that the technology industry’s commitment to the environment and workforce diversity is responsible for their high weightages in the indexes. But other industries have ranked higher on the same criteria. For example, a study by the Wall Street Journal last year ranked the information technology industry sixth last year, after financials, communication services, consumer staples, consumer discretionary, and health care, in diversity rankings. 

Even the presence of notable money managers that profess to adhere to ESG investment criteria has not made a significant dent in climate change. In fact, research from investment campaign group ShareAction found that Vanguard and Blackrock gave their support to less than a sixth of climate change action. Blackrock voted in favor of climate change action 11% of the time while Vanguard voted in favor of climate change resolutions just 15% of the time. 

And what of the polluters?

According to the EPA, the transportation and energy industries are responsible for the maximum number of carbon emissions. At the Brown Advisory Sustainable Growth Fund, which has assets worth $3.5 billion under management, energy accounts for just 0.1 percent of the benchmark holdings. The Vanguard ESG U.S. stock fund has set aside just 1.30% and 0.2% of its $2.5 billion assets under management for utilities and energy firms respectively. Utilities included in the fund, such as NextEra Energy and Exelon, already have high stock market valuations. Meanwhile, thirty percent of the fund’s holdings consist of tech stocks.

With more than $12 billion assets under management, the iShares ESG Aware MSCI ETF is the biggest fish in the ESG pond. Tech conglomerates Amazon, Facebook, et al., are its top five holdings. Oil and gas majors Exxon and Chevron, hardly the poster children for climate change or diversity, are also in the fund’s holdings. Alas, renewable energy or solar firms do not make the list.

Market Performance is ESG Performance

ESG funds outperformed the S&P 500 by between one to seven percentage points for the first ten months, according to Barrons. As revenues and profits for other sectors reeled under the weight of pandemic shutdowns, prospects for the tech sector rose. That is when ESG funds rotated into the biggest tech stocks. Immediately after Biden’s election, when hopes of an economic stimulus and recovery rose, they rotated out of tech stocks and into other cyclical sectors.

The bet proved prescient as the upward trajectory of tech stocks encountered skids and other sectors began moving up. By frontloading their holdings with tech stocks, ESG funds have ensured that they mimic market movements. This strategy might translate to profits for investors but they don’t make a substantial difference to climate change or social governance initiatives. 


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