On November 22, 2022, the U.S. Department of Labor finalized a rule that allows retirement plan fiduciaries to consider climate change and other environmental, social and governance (ESG) factors when they select retirement investments. We suspect that this new rule will lead to increased demand for ESG investment products as they show up in more 401(k) plans. Now may be a good time to review the history of ESG investing, as well as its benefits and our concerns.

Early History of ESG Investing

Socially responsible investing, or sustainable investing, is not a new concept. The first socially responsible investing (SRI) mutual fund was launched in 1971 by Pax World. The fund was founded by two United Methodist ministers who wanted to avoid investing church dollars in companies contributing to the Vietnam War. Early SRI funds were often focused on avoiding “sin” stocks, which were companies involved in the alcohol, tobacco, firearms and gambling industries. Over the next 35 years, the number of SRI funds grew from one to 60 in 2006. Around that time, the term ESG was introduced to represent sustainable investing.

Recent Growth of ESG

As shown in the chart below, money has poured into ESG products over the last few years. While some of the popularity of ESG funds has been driven by investors acting on principle, it should be noted that some of these flows were driven by investors chasing performance. Most ESG funds were underweight fossil fuel company stocks and overweight technology stocks over the last five years, a period when fossil fuels underperformed and technology outperformed. For a period of years, ESG funds were not only popular among some for reasons of principle, but they also had good relative performance. Since the drastic reversal of these trends in 2022, flows into ESG products have slowed dramatically. However, net flows into ESG funds still grew 2.5% in the first half of the year, which contrasts with the net outflows for the overall U.S. market.

Wall Street Enters the Chat

As seen by the numbers in the previous paragraph, ESG investing is a growing market. And wherever there is a growing market, Wall Street is not far behind looking for a way to profit. In the first six months of 2022, 56 new ESG funds were launched. New ESG funds were being created at an even faster pace in 2021 when the stock market was making new highs. Eighty-three funds with sustainable mandates were opened in the U.S. during the final six months of 2021. The number of new funds does not include 19 repurposed funds. A fund is repurposed when a firm changes the investment strategy of an existing fund to a new strategy. We would suggest that repurposing a traditional fund into an ESG fund is taking advantage of gullible investors by selling them what they want to buy instead of what is in their best interest. An example of repurposing occurred in May 2022 when the Franklin Liberty Federal Tax-Free Bond ETF became the Franklin Municipal Green Bond ETF. Sounds more attractive than a typical muni bond fund, right? Through June 30, there were 588 ESG open-end funds and ETFs. Of these 588 funds, 158 (27%) of them have been launched or repurposed within the last year. Wall Street never fails to sell investors what they want to buy. In 1999, near the top of the tech bubble, a multitude of tech funds were launched and marketed. Even low-cost provider Vanguard is expanding their ESG lineup, launching the Global Environmental Opportunities Stock Fund in November 2022 at a 0.60% expense ratio for their Admiral share class. That is much more expensive than the typical Vanguard fund.

Regulation

While Wall Street was quick to warm up to ESG, regulators are still trying to figure out how to regulate the space. It has become very political. After pulling back on regulation of ESG, and especially climate-related issues during the years of the Trump presidency, the Securities and Exchange Commission (SEC) has moved aggressively under the Biden administration to create new regulation that would apply to investment managers and to corporations in general. For example, the SEC has been focusing on past disclosures made by funds to make sure their investing practices sync with what the funds are telling shareholders. Making deceptive claims which overstate the degree to which a portfolio invests in sustainable companies is known as “greenwashing.” The SEC has launched investigations into Goldman Sachs and Deutsche Bank’s DWS unit over allegations of greenwashing that are still pending.

In March 2022, the SEC proposed rule amendments that would require public companies to provide climate-related financial data and greenhouse gas emissions insights in public disclosure filings. This rule would have far-reaching impact and is currently on hold while the SEC reviews thousands of comments submitted by those affected.

ESG Backlash

In August 2022, the Florida State Board of Administration, made up of Governor Ron DeSantis, the Florida CFO and the Florida Attorney General, passed a resolution that all decisions related to the investment management of the Florida Retirement System will not include ESG considerations. Then in October, the Louisiana treasurer said he would divest $794 million in state money from BlackRock Inc. funds because “ESG investing violates Louisiana law on the fiduciary duties which require a sole focus on financial returns for the beneficiaries of state funds.” BlackRock is the world’s largest asset manager and owner of iShares.

BlackRock CEO Larry Fink said earlier this year that “BlackRock does not pursue divestment from oil and gas companies as a policy.” That comment did little to calm some lawmakers who believe the company is abusing its power to force an agenda. Blackrock is also criticized by environmental activists, who say it should cut ties with fossil fuel companies that do not reduce their emissions.

Benefits of ESG Investing

Values-aligned investing: Perhaps the primary benefit of ESG investing is that it expands choice in the investment universe. Eighty-seven percent of plan participants in the Schroders 2022 U.S. Retirement Survey said they want their finances to be aligned with their values. ESG investing introduces another way for investors to address that concern.

Influencing corporate behavior: The surge in ESG investing and the actions of regulatory agencies have led companies to take action regarding environmental, social and governance issues. Even companies in the energy and utilities sectors, which are usually not viewed favorably by ESG products, have taken significant steps to reduce their carbon emissions. As recently as 2019, only 11 of the S&P 500 companies referenced ESG in their quarterly earnings calls. In less than three years, that number jumped over 1300% to 155.

According to the Center of Audit Quality (CAQ), 464 companies—93% of the S&P 500—issued an ESG report referencing at least one commonly used ESG reporting standard or framework through 2020. I believe that number has grown since, as I was unable to find a company that did not have an ESG report or section on their website.

ESG awareness appears to be more than lip service and is not limited to U.S. large-cap companies. Small-cap and international companies are also making significant changes in areas such as board diversification and climate pledges. As an example of a climate pledge, mining company Rio Tinto increased their climate change targets: 15% reduction in Scope 1 and 2 emissions by 2025—five years faster than original target—and a 50% reduction in Scope 1 and 2 emissions by 2030—three times higher than the original target.

According to ISS Corporate Solutions, nonwhite ethnic groups held 4,500 board seats among companies in the Russell 3000 all-cap stock index at the end of 2021. That is nearly 50 percent more than just two years earlier. Women have made recent gains in board representation as well, as they accounted for 27% of all director spots last year, up from 24% in 2020.

Concerns with ESG Investing

Despite the benefits of socially responsible investing, there are concerns to be aware of:

Increased cost or a “greenium”: According to a study by Morningstar, average annual fees for sustainable funds (0.61%) are almost 50% higher than fees for traditional funds. When comparing passively managed funds from the same fund company, ESG funds are still far more expensive. iShares ESG Aware MSCI USA ETF has an annual expense ratio of 0.15%, which is five times greater than iShares Core S&P 500 ETF’s annual expense ratio of 0.03%.

Inconsistent ratings: While socially responsible investing is not a new field, ESG ratings are relatively new. In research done by the MIT Sloan Sustainability Initiative, the correlation among six prominent ratings providers was on average 0.61. For comparison, the correlation of the two largest bond rating agencies (Moody’s and Standard & Poor’s) is 0.99. The low correlation is not surprising when you learn that of the 64 categories used by the six providers, only ten categories are common to all six firms. Not only are the categories difficult to agree on, but so are the weighting and scoring of each category.

As a result, you will find many instances of ESG ratings firms evaluating the same company much differently. In May 2021, The Wall Street Journal analyzed the ESG grades of nearly 1,500 companies from three ratings firms—Refinitiv Holdings Ltd., MSCI Inc. and Sustainalytics. Nearly two-thirds of the companies received different grades from the firms. Scarier is the finding that almost one-third of the companies were called an ESG leader by one or more rating firms but determined to be an ESG laggard by at least one of the other firms.

Inconsistent holdings: Inconsistent ratings will lead to indices and funds with significantly different holdings. In May 2022, Tesla was kicked out of S&P 500 ESG Index and ETF (EFIV) for workplace and governance issues. Tesla also showed up at #21 (Exxon Mobil was #25) on the Toxic 100 Air Polluters Index, compiled annually by the U-Mass Amherst Political Economy Research Institute. Exxon Mobil is the seventh-largest holding in the S&P 500 ESG ETF. Elon Musk replied to that news saying, “ESG is a scam. It has been weaponized by phony social justice warriors.” Twitter was added to the S&P 500 ESG Index in the same May update. Elon Musk must have really wanted to be back in the S&P 500 ESG Index!

Jokes aside, Tesla is held in the two largest ESG ETFs. In the iShares ESG Aware MSCI USA ETF (ESGU), Tesla is the sixth-largest holding; Exxon Mobil is #10. Tesla is the fourth-largest holding in the Vanguard ESG U.S. Stock ETF (ESGV); Exxon Mobil is not among the 1,482 stocks in the ETF. Please know what you own if you are investing in ESG funds. Your main reason for investing in ESG may be to avoid owning fossil fuels. Yet, if you own the largest ESG ETF available, you hold as much in energy stocks as the S&P 500 Index.

Inconsistent performance: The largest ESG ETF is the iShares ESG Aware MSCI USA ETF, which was created in December 2016. You may not find it surprising that ESG funds were outperforming traditional funds from 2018 to 2020 when ESG net flows were setting records every year. From inception through October 2022, the iShares ESG Aware ETF has outperformed the iShares Core S&P 500 ETF (+74.55% to +72.36%). However, since the end of 2020, S&P 500 ETF has outperformed the ESG Aware ETF (+3.30% vs. -0.33%).

Inconsistent sector weights: One of the reasons many ESG funds have underperformed over the last few years is their lack of exposure to the energy sector. From the market low hit in March 2020 through October 2022, the energy sector is up 330.8%. The next-highest performing sector in the S&P 500 is materials, which is up 102.9%. In 2022 through October, energy is up 68.6%. None of the other ten sectors have a positive return this year. Not all ESG funds are constructed similarly, though. Reviewing the two largest U.S large cap ESG ETFs, the iShares ETF holds 5.44% energy stocks while the Vanguard ETF only holds 0.02% energy stocks.

CONCLUSION

Further standardization and transparency of ESG rankings needs to occur. Will they be able to achieve that goal, considering how subjective ESG factors are? From the SEC website: “There is no SEC rating or score of E, S, and G that can be applied across a broad range of companies, and while many different private ratings based on different ESG factors exist, they often differ significantly from each other.” We may be waiting awhile to see consistency from ratings providers.

As you consider the investment universe, we think it is important to acknowledge the forces at play—Wall Street’s profit motivation, the political environment, investor emotions and importantly, your own priorities. At Bragg, unless directed by our client, we do not directly screen the individual stocks we buy using ESG ratings firms. However, 66 of the 69 stocks we buy are in the major ESG ETFs (all three outliers are energy or utility stocks). We will exclude a stock for you upon request. We do not hold ourselves out as ESG investors, but we removed Wells Fargo from client portfolios as a result of their fake account scandal in 2016–2017. According to a study by Research Affiliates in 2017, one ratings provider ranked Wells Fargo in the bottom 5% by governance in their universe, while another ranked it in the top third!

We are constantly monitoring the companies you own in your accounts.

At Bragg, we believe the market is quite efficient. In well-run companies, corporate managers are highly incentivized to maximize long-term shareholder returns. Of course, by default, this should include considering the environment, human rights and equal treatment of people. But capitalism’s track record isn’t perfect—poorly structured incentives can cause bad behavior. Capitalism’s natural incentives for sustainability can be bolstered by shareholder advocacy, diligent and fair reporting by the media and appropriate levels of regulation. These can combine to create an environment for progress. We’ve certainly seen this over the last 200 years.

This information is believed to be accurate but should not be used as specific investment or tax advice. You should always consult your tax professional or other advisors before acting on the ideas presented here.