Is ESG facing an identity crisis?

Sustainability investing has long been enjoying growing popularity, but has been cast in a somewhat negative light lately. Greenwashing scandals, calls for stricter regulation, and definition problems were joined in the first half of this year by a poor return performance. The investment industry evidently faces challenges with regard to ESG, but it is premature to sound the death knell for the sustainability megatrend.


Headwinds for three capital letters…

The first half of this year was a stormy time, and not just on the financial markets. The past months were turbulent also in the world of sustainability investing, a universe that more and more investors have discovered in recent years. The police raid of the offices of mutual fund company DWS and the resignation of DWS CEO Asoka Wöhrmann in mid-June potentially marked just a preliminary crescendo in efforts by regulators to crack down on the greenwashing of financial products. Earlier, in May, the US Securities and Exchange Commission (SEC) slapped a USD 1.5 million fine on asset management company BNY Mellon as a punishment for greenwashing offenses. The thumbscrews look set to be tightened even further soon. The SEC, for example, has proposed two new rules that would require greater transparency from US mutual funds and would set a stricter definition of what qualifies for the ESG label. Meanwhile, regulatory authorities in Europe intend to also tackle the long-known problem surrounding ESG ratings because the ESG scores issued by the various rating providers differ greatly from each other in some cases. This was verified once more by a recently updated research paper1, which found only a weak to moderate correlation (ranging between 0.38 and 0.71) between ESG ratings issued by six prominent ESG rating agencies. This is far lower than the correlation between conventional credit ratings (0.92).

But the alleged (identity) crisis afflicting sustainability investing also stems from macro- and geopolitical developments that unfolded in the first half of this year, particularly the armed conflict in Ukraine and its consequences. They have forced companies, investors and governments to deal more intensively with the letters E (environmental), S (social) and G (corporate governance), which sometimes seem like they are being played off against each other. Several governments in Europe, for example, are backing away from their environmental objectives and are turning to fossil fuels to reduce their dependence on Russian natural gas and thus meet ethical aims. And the infighting within the European Union over the EU taxonomy’s seal of sustainability for atomic energy and natural gas has taken on a particularly explosive nature in the face of soaring energy prices. In light of the military escalation in eastern Europe, some observers ultimately are asking whether even the arms industry should also be deemed sustainable (in part) and whether entire countries (i.e. Russia in this case) should be considered uninvestable from an ESG standpoint.


…and a poor(er) performance to boot

The disappointing year-to-date performance of sustainable investments both in absolute return figures and relative terms (compared to non-sustainable investments) is not exactly helpful to their image. But it is explicable and actually shouldn’t surprise anyone because it’s no secret that ESG investments tend to have a bias toward the growth investment style and the technology sector, which explains their prior outperformance in recent years. The underperformance versus the MSCI World Index posted by the MSCI World ESG Leaders Index (-0.6 percentage points) and the MSCI World SRI Index (–3.5 percentage points) for the first half of 2022 was attributable primarily to two factors. First of all, shares of companies rated as being (more) sustainable are more expensively valued on average in terms of classic valuation metrics (e.g. price-to-earnings and price-to-book-value ratios). Those enterprises generally tend to be growth companies that have been hit harder than others in recent months by rising bonds yields. Secondly, the information technology and communication services sectors have comparatively higher weights in ESG indices while the energy industry, which tops the sector performance leaderboard by a wide margin this year, is significantly underweighted in them. Since the ESG indices cited above and corresponding ETFs on those indices try to minimize tracking error against the MSCI World Index (and ultimately also try to keep sector weighting deviations as small as possible), their underperformance so far this year has been noticeable but not particularly substantial. The underperformance may look different, though, for “stricter” strategies (many of which are actively managed) that allow bigger deviations and entirely exclude companies and sectors with a poor ESG profile.


Bringing up the rear for a change | ESG indices are lagging behind this year

Performance comparison: MSCI World vs. ESG indices

Sources: Bloomberg, Kaiser Partner Privatbank


More technology… | …and less energy

Comparison of valuation ratios and weightings: MSCI World vs. ESG indices

Sources: MSCI, Kaiser Partner Privatbank


It was never about outperformance

The recent below-average return performance of sustainability-minded investors’ asset holdings is not necessarily heartening for the right hemisphere of their brains (which is dominant in processing emotions), but it marks a good occasion to give the left cerebral hemisphere (where analytical thinking takes place) food for thought and to review the sense and purpose of sustainable investment, as well as to revisit one’s own understanding of what it means to invest sustainably. ESG investing, in our view, is not an investment strategy with systematic outperformance potential, but is rather an investor preference. A meta-study conducted by the University of Bremencorroborates the first part of our opinion above and comes to the conclusion that values-based socially responsible investments (SRI) perform neither above average nor below average over the longer term.

We think that analyzing ESG criteria is first and foremost a tool for identifying risks that are not (yet) priced in on the financial markets. Performing an ESG analysis helps an investor to avoid such risks. Although this does not lead to an excess return in the long run, it does deliver the same return for less risk. But what not all ESG investments do is make the world fundamentally more sustainable or turn the Earth into a greener planet. And herein lies part of the greenwashing problem when something that is actually a risk management instrument is sold to (or interpreted by) the general public as being a tool for improving the world.


Growing into adulthood

If (justified) greenwashing concerns are one side of the medallion, (undifferentiated) ESG bashing is the obverse side. Recent weeks, in fact, have seen a media upswell also of articles that have taken an unnuanced look at the highly complex set of issues and have fundamentally called the entire ESG concept into question. But it is premature to sound the death knell for the sustainability megatrend. A fairer appraisal would go something like this: ESG investing registered unprecedented growth over the last four years and became part of the mainstream. Oodles of new investment products were launched, and just as many claims (or promises?) about them were made. But the unprecedented growth was not accompanied by an equivalently maturely developed ESG toolbox. ESG reporting standards, which are hardly practicable at present, are just one example of this. The rise in greenwashing accusations can therefore be benevolently interpreted as a natural consequence of the success of sustainability investing. What are needed in the future are a clearer regulatory framework, more coherent guidelines, and more precise and uniform definitions. A better demarcation between the three letters E, S and G (risk management) and the conception of sustainable investment (environmental impact) is necessary, for example. The how and what of impact investments (direct, measurable effect) should also be more sharply defined. Regulators around the world face a mammoth task, but they’re already on their way to tackling it because they have recognized the obviously existing problems. If their efforts bear fruit, a few years from now we will look back on the awkward adolescence of ESG and will be living in an ESG 2.0 investment world with tighter regulation and with products that honestly disclose what they do and what they don’t do.


1 F. Berg, J.F. Kölbel, R. Rigobon (MIT, Universität Zürich): «Aggregate Confusion: The Divergence of ESG Ratings»

2 L. Hornuf, G. Yüksel: «The Performance of Socially Repsonsible Investments: A Meta-Analysis»


Oliver Hackel, CFA Senior Investment Strategist

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