Sustainable Investing Failed Its First Big Test
Is a reckoning coming?
Is a reckoning coming?
The past few years have seen an explosion of interest in investing based on environmental, social, and governance factors, or ESG. Lured by the promise of doing well by doing good, investors poured billions of dollars into ESG strategies, turning the acronym into one of Wall Street’s favourite buzzwords.
As the approach soared in popularity, investment companies large and small seized the opportunity to design and market new ESG funds and rankings. Professionally managed assets with ESG mandates swelled to $46 trillion globally in 2021, representing nearly 40% of all assets under management, according to Deloitte’s Center for Financial Services. By 2024, that figure is forecast to rise to $80 trillion, or more than half of all professionally managed assets.
Now, Russia’s invasion of Ukraine has created the first real test for this popular investment trend. By eschewing traditional energy stocks and defence shares, which are having a banner year, and embracing low-carbon-footprint technology stocks, which aren’t, many ESG funds lost money in the first quarter, and underperformed their benchmarks.
One quarter isn’t indicative of a long-term trend, but the poor performance has pointed out some of the weaknesses inherent in this investment approach, and offered fresh ammunition to critics, of whom there are many. It also suggests that ESG strategies, often focused on environmental issues, need a rethink, with more emphasis placed on social factors, especially in light of Europe’s growing humanitarian crisis.
“There is going to be a reckoning in ESG,” says Jason Saul, executive director of the Center for Impact Sciences at the University of Chicago Harris School of Public Policy. “ESG is an investment thesis that needs to evolve with the times.”
Aswath Damodaran, a professor at New York University’s Stern School of Business, and an expert in equity valuation, calls the Russia-Ukraine war “the first of many tests that are going to come” for ESG. One of Damodaran’s chief criticisms is that the industry has oversold outperformance, when almost all of the returns in ESG strategies could be attributed to funds’ tech focus and avoidance of fossil-fuel stocks, poor performers until the past year.
Some investors have embraced ESG as a moral imperative, but many of the strategy’s fans have invested in ESG-oriented or “sustainable” funds—the terms are often used interchangeably—in the belief that companies that adhere to good environmental, social, and governance practices may outperform those that don’t. Investors worried about sacrificing returns could find reassurance in ESG’s report card: In the decade from 2012 to 2021, all large-cap U.S. stock funds returned an annualized 14.87%, while the ESG-focused funds in that group returned 15.58%, according to data from Morningstar Direct.
Both groups, however, failed to outpace the broader market, as measured by the S&P 500 index, which returned 16.55% a year during the same period.
But that doesn’t mean investors didn’t do well. On an asset-weighted basis, large-cap ESG funds delivered an annualized 16.49% per invested dollar, almost on par with the S&P 500, according to Morningstar Direct.
The outperformance of ESG was even more striking in the past two years. In 2020 and 2021, all large-cap U.S. stock funds returned 23.39% a year per invested dollar, largely the same as the S&P 500. But ESG-focused large-cap funds returned 25.19%.
This year tells a different story, however. In the first quarter, all large-cap U.S. stock funds fell an average of 5.6% on an asset-weighted basis, according to Morningstar. The ESG funds in the group fell almost 7% in the three months ended on March 31.
“We’re kind of in a shakeout, and ESG will likely get its nose bloodied a little,” says Matt Orsagh, a senior director of capital-markets policy at the CFA Institute, the global association of investment professionals.
Inflation is perhaps the biggest culprit in ESG funds’ recent underperformance. U.S. inflation, as measured by the consumer price index, surged at an annual pace of 8.5% in March—the seventh straight monthly increase and the country’s highest inflation rate in more than 40 years.
March CPI rose 1.2%, the Department of Labor reported on Tuesday, up from 0.8% in February. Gasoline, shelter, and food costs contributed the most to headline inflation: Gas prices rose 18.3% in the month.
The war in Ukraine, now in its second month, has contributed to the rise in energy and other commodity prices, aggravating global inflation. Brent crude, the international benchmark for oil prices, is up more than 40% year to date, with the rally underpinning a total return of 45% in the Energy Select Sector SPDR exchange-traded fund (ticker: XLE).
Yet many ESG funds are underweight oil and gas stocks, which typically don’t make it past their screens due to the industry’s climate-unfriendly characteristics. Environmental, social, and governance funds around the globe that report holdings monthly had only a 1.5% weighting in energy as of February, versus 4% for all stock funds, according to EPFR Global, which tracks fund flows and holdings.
Technology, on the other hand, has been a favorite of global ESG funds, accounting for more than 25% of their total assets as of Feb. 28, according to EPFR. That’s nearly two percentage points more than tech’s exposure in all stock funds. But tech stocks, and growth stocks generally, had a troubled first quarter as the Federal Reserve raised interest rates for the first time since 2018. The Technology Sector Select SPDR ETF (XLK), a proxy for the sector, lost almost 9%. Microsoft (MSFT), one of its top holdings, is an ESG fund favorite.
ESG’s underperformance “is going to be the steady state,” Damodaran says.
Ken Pucker, a senior lecturer at the Fletcher School at Tufts University, is in Damodaran’s camp on this subject. He says that ESG funds don’t systematically deliver alpha, or the excess return of an investment, relative to the return of a benchmark index. He also contends that they oversell outperformance and charge higher fees compared with plain-vanilla funds.
In a recent essay published in Institutional Investor, Pucker and co-author Andrew King, a professor at the Questrom School of Business at Boston University, discussed interviewing more than a dozen investment professionals to investigate their claims that a focus on ESG produces higher profits, signals higher stock returns, lowers capital costs, and benefits from investment flows. Pucker and King concluded, “The logic and evidence for assurances of ESG-driven alpha are lacking. Indeed, it is our best guess that flows of money into ESG funds represent a marketing-induced trend that will neither benefit the planet nor provide investors with higher returns.”
To be sure, ESG managers and advocates disagree. They note that the strategy aims to deliver long-term value, and that all investment styles have stretches of underperformance. Amber Fairbanks, a portfolio manager at Mirova US, the sustainable-investing affiliate of Natixis Investment Managers, acknowledges that ESG managers have underperformed fairly significantly, year to date, but says that “the underlying conviction is really on the longer term, and that’s where, as an ESG manager, we’re looking to outperform.”
“What strategy doesn’t have a poor one or two quarters?” says Emily Chew, executive vice president and chief responsible-investment officer of Calvert Research and Management, the sustainability powerhouse owned by Eaton Vance. “ESG remains a very robust framework for thinking about the overall context in which a company is operating.”
Critics have long argued that investors are overpaying for ESG products. It isn’t that the funds charge more than their peers: According to Morningstar Direct, actively managed stock funds in the U.S. had an average net expense ratio of 1.12% as of February 2022, while the ESG funds in the group charged an average of 1.04%. Similarly, index-tracking sustainable funds have slightly lower average costs than all passive stock funds.
But ESG investors seem more willing to pay higher expenses than investors overall. On an asset-weighted basis, investors in all active stock funds pay 0.67% for each dollar invested, and investors in ESG funds, 0.78%. Among index funds, the gap is even wider. On the same basis, the expense ratio for passive ESG funds, at 0.25%, is more than twice the average for all passive stock funds.
ESG has deep roots in Europe, where politicians have long pushed for rules to bring companies in line with the European Union’s long-term carbon neutrality target. In the U.S., critics dismissed the focus as a fad. But the strategy gained momentum here in 2019 and 2020, as headlines about extreme-weather events, the Covid-19 pandemic, and social-justice issues, including those highlighted by the death of George Floyd in police custody, prompted many investors to focus more on environmental and social problems.
Last year saw record net inflows of $69.2 billion into sustainable open-end and exchange-traded funds available to U.S. investors, a 35% increase over the previous record set the year before, according to Morningstar. Observers proclaimed that ESG had finally moved into the mainstream.
In fact, the seeds had been sown years before. ESG trailblazer Amy Domini co-founded KLD Research & Analytics in 1990, and created the Domini 400 Social Index. Soon after, she launched a passive U.S. equity fund pegged to the index. The firm and its flagship index are now owned by MSCI (MSCI), the largest ESG rating company. The fund converted to an active strategy, via the Domini Impact Equity fund (DSEPX), in 2006. Last year, it returned 21.3% but is down 12% this year.
MSCI declined to comment for this article.
CFA’s Orsagh remembers when the ESG acronym was coined in 2005. In the early 2000s, he worked at GovernanceMetrics International, now part of MSCI. He says ESG was born of the need to integrate nonfinancial information into the investment process. “ESG is an ethos; it’s not an investment style,” he says. “It was meant to find ways for investors to have better information to efficiently allocate capital.”
Over the years, it became synonymous in some investors’ minds with the catchphrase “doing well by doing good.” For others, it is regarded primarily as a risk-mitigation strategy. Semantics aside, the strategy got a big boost when one of the best-known names in finance—Larry Fink, chief executive of BlackRock (BLK), the world’s largest asset manager—took the bullhorn.
In his 2018 letter to CEOs, Fink implored other chief executives to be more thoughtful about their roles. “Society is demanding that companies, both public and private, serve a social purpose,” he wrote. “To prosper over time, every company must not only deliver financial performance, but also show how it makes a positive contribution to society.”
Later that year, Fink signaled that the industry was at an inflection point. “I do believe that the demand for ESG is going to transform all investing,” he said, referring to both passive and active investors. “That may be one or five years away from now, but it’s not that far away.”
That year, sustainable mutual and exchange-traded funds in the U.S. held US$89 billion in assets, according to Morningstar. At the end of 2021, just three years later, that number had ballooned to $360 billion. Still, that’s just a sliver of the $28 trillion in total U.S. fund assets.
During BlackRock’s first-quarter earnings call on Wednesday, Fink reiterated the company’s commitment to sustainable investing. He acknowledged during the Q&A portion of the call the “severe impact” that higher energy prices and inflation have had on many people, but said this doesn’t change “the long-term nature of ESG.”
Fink cited first-quarter fund flows as evidence, saying, “We had about $19 billion of sustainable flows. Obviously, that’s down from prior quarters, but certainly up from two years ago.”
BlackRock declined to make executives available for an interview, referring Barron’s instead to Fink’s 2022 letter to shareholders.
As environmental, social, and governance assets under management have swelled in the U.S., so have investors’ choices. According to ISS Market Intelligence, fund firms launched a record 133 ESG funds in 2021. That’s up from the 75 that debuted in 2020.
Ironically, given the growth in products, there is no established standard for what constitutes ESG investing—and no standard-setting organization. Even the two dominant U.S. ratings companies—MSCI and Morningstar, which owns Sustainalytics, an ESG ratings and research firm—differ somewhat in their approach. Sustainalytics’ ESG Risk Ratings measures a company’s exposure to industry-specific material ESG risks and how well the company is managing those risks. MSCI ESG Ratings measures a company’s exposure to ESG risks and how well the company manages those risks, relative to peers.
Jon Hale, head of sustainability research at Morningstar, agrees that the terminology around ESG and sustainability is fraught. “I tend to use ‘sustainable investing’ as an umbrella term to refer to a range of investment approaches that seek to both deliver competitive investment returns and positive ESG outcomes,” he says.
“There’s a multitude of rating agencies out there,” says Douglas Chia, president of consulting firm Soundboard Governance, who notes that investors are starting to ask more questions about the rating methodologies, how the firms are collecting the information, and what the information actually means. “To determine the quality of the disclosures that ratings agencies are evaluating, you do have to have metrics, and they have to be required, so that they are comparable and auditable, or attestable, or something like that,” he adds. “And that’s what the SEC [Securities and Exchange Commission] is attempting to do, and what a lot of jurisdictions are attempting to do.”
The SEC proposed new rules in March that would require U.S. public companies to report their greenhouse-gas emissions, along with details of how climate change is affecting their businesses.
In its report, ISS MI found that fund managers courted ESG investors by adding environmental, social, and governance criteria to funds already in the market. The number of funds adding such language peaked in 2020, with 200, representing nearly $1 trillion in assets under management, the firm said. Last year, 136 funds, representing about $300 billion in AUM, began using ESG criteria in some fashion.
Today, the sector has effectively become an industry—or Big ESG, as Chia says—encompassing asset managers, proxy advisors, ratings firms, consultants, and others. And it continues to grow: PwC, the business-services firm, announced plans last year to create 100,000 net new jobs in the next five years with an emphasis on “hiring specialists in critical areas, many related to ESG, including climate, supply chain, and leadership and change.” It has also created an ESG Academy for its workforce to raise awareness of and insight into ESG principles.
This past week, Deloitte said that it is committing $1 billion to expand its sustainability and climate practice and launching the new Deloitte Center for Sustainable Progress, or DCSP.
There is plenty of momentum and marketing muscle behind ESG, and a generation of mostly younger investors who care deeply about the planet and social issues. But investors’ appetite for underperformance could be tested in the coming months.
“ESG overpromised, and nothing focuses people’s minds like a quarter of underperformance on the thesis that they’ve been buying into,” says Orsagh. If the underperformance drags on, some ESG investors will probably look elsewhere for returns. In the near term, they might need to rethink the companies they are willing to invest in.
Zhihan Ma, global head of ESG and senior ESG analyst at Bernstein, says that the war in Ukraine and persistently high inflation are challenging the conventional wisdom about sustainable investing. “On the one hand, the conventional wisdom says you get impact and returns, and on the other hand, it says ESG investing is about investing in best-of-class names,” Ma says, referring to companies with high ESG scores, typically in the tech sector. “But investing in best-in-class names may not get you impact and returns at the same time in all market conditions.”
Ma is sanguine about the long-term prospects for ESG. “We’re not going to solve climate change overnight; we’re not going to solve rising inequalities overnight,” she says. “There are systemic issues in society that all stakeholders, regulators, investors, consumers, companies will need to work on together to address, which means that all these considerations are here to stay.”
She says the “S,” or social issues, became a more pressing concern during the peak of the Covid pandemic, and amid rising racial tensions. “We could see more interest in the S if the war leads to a prolonged humanitarian crisis,” she says.
One challenge is measuring the S, which seems even more complicated than quantifying environmental impact and risks. BNP Paribas’ 2021 ESG Global Survey found that 51% of respondents said the S is the most difficult ESG concept to analyse and embed in investment strategies. “Data [are] more difficult to come by, and there is an acute lack of standardization around social metrics,” the report said. “This comes at a time when the social component is of growing importance to end investors.”
Saul, at the Center for Impact Studies, tackled the topic in a recent paper titled “Fixing the S in ESG.” He wrote: “To be relevant, the ESG field must modernize the way it measures S factors.”
This requires an objective standard for reporting social outcomes, which has been lacking to date. Then, once the impacts are standardized and classified, they must be verified by an independent body. And third, there needs to be better reporting.
To elevate the importance of S, companies need to move beyond a check-the-box exercise. Saul says that they should start reporting social impact data consistently. Environmental, social, and governance investors should start asking for and requiring S impact data, and ESG rating firms, standard-setting bodies, and data providers should align with a specialized S data provider to improve the value of their data.
He says that the group’s performance has suffered since the start of the Ukraine war because the industry is “monocularly tied to E and investors haven’t given enough consideration to the importance of S.” ESG, he adds, “has to be based on something more substantial than just quantifying carbon and E.”
Kathryn McDonald, co-founder of RadiantESG Global Investors and head of investments and sustainability, says there has rightly been an emphasis on environmental issues, given the existential threat posed by climate catastrophes. But it is becoming clear that “social challenges give rise to myriad risks affecting our investments and our economy more generally,” she says. ‘These threats aren’t on the distant horizon. They are with us now.”
ESG has captured investors’ attention and that of Wall Street, and interest in this investment approach—not to mention the apparatus built to support it—isn’t going to disappear. But the strategy could face more tests in coming quarters and years, due to market swings, investor biases, and the inherent challenges of defining and measuring environmental, social, and governance impact and risk. How ESG funds perform ultimately will determine whether the concept flourishes and is enshrined in mainstream investing—or whether it becomes a passing fad.
Reprinted by permission of Barron’s. Copyright 2021 Dow Jones & Company. Inc. All Rights Reserved Worldwide. Original date of publication: April 17, 2022.
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Crypto’s lack of connections with traditional finance means its problems haven’t spilled over to the economy
This year’s crypto collapse has all the hallmarks of a classic banking crisis: runs, fire sales, contagion.
What it doesn’t have are banks.
Check out the bankruptcy filings of crypto platforms Voyager Digital Holdings Inc., Celsius Network LLC and FTX Trading Ltd. and hedge fund Three Arrows Capital, and you won’t find any banks listed among their largest creditors.
While bankruptcy filings aren’t entirely clear, they describe many of the largest creditors as customers or other crypto-related companies. Crypto companies, in other words, operate in a closed loop, deeply interconnected within that loop but with few apparent connections of significance to traditional finance. This explains how an asset class once worth roughly $3 trillion could lose 72% of its value, and prominent intermediaries could go bust, with no discernible spillovers to the financial system.
“Crypto space…is largely circular,” Yale University economist Gary Gorton and University of Michigan law professor Jeffery Zhang write in a forthcoming paper. “Once crypto banks obtain deposits from investors, these firms borrow, lend, and trade with themselves. They do not interact with firms connected to the real economy.”
A few years from now, things might have been different, given the intensifying pressure on regulators and bankers to embrace crypto. The crypto meltdown may have prevented that—and a much wider crisis.
Crypto has long been marketed as an unregulated, anonymous, frictionless, more accessible alternative to traditional banks and currencies. Yet its mushrooming ecosystem looks a lot like the banking system, accepting deposits and making loans. Messrs. Gorton and Zhang write, “Crypto lending platforms recreated banking all over again… if an entity engages in borrowing and lending, it is economically equivalent to a bank even if it’s not labeled as one.”
And just like the banking system, crypto is leveraged and interconnected, and thus vulnerable to debilitating runs and contagion. This year’s crisis began in May when TerraUSD, a purported stablecoin—i.e., a cryptocurrency that aimed to sustain a constant value against the dollar—collapsed as investors lost faith in its backing asset, a token called Luna. Rumours that Celsius had lost money on Terra and Luna led to a run on its deposits and in July Celsius filed for bankruptcy protection.
Three Arrows, a crypto hedge fund that had invested in Luna, had to liquidate. Losses on a loan to Three Arrows and contagion from Celsius forced Voyager into bankruptcy protection.
Meanwhile FTX’s trading affiliate Alameda Research and Voyager had lent to each other, and Alameda and Celsius also had exposure to each other. But it was the linkages between FTX and Alameda that were the two companies’ undoing. Like many platforms, FTX issued its own cryptocurrency, FTT. After this was revealed to be Alameda’s main asset, Binance, another major platform, said it would dump its own FTT holdings, setting off the run that triggered FTX’s collapse.
Genesis Global Capital, another crypto lender, had exposure to both Three Arrows and Alameda. It has suspended withdrawals and sought outside cash in the wake of FTX’s demise. BlockFi, another crypto lender with exposure to FTX and Alameda, is preparing a bankruptcy filing, the Journal has reported.
The density of connections between these players is nicely illustrated with a sprawling diagram in an October report by the Financial Stability Oversight Council, which brings together federal financial regulators.
To historians, this litany of contagion and collapse is reminiscent of the free banking era from 1837 to 1863 when banks issued their own bank notes, fraud proliferated, and runs, suspensions of withdrawals, and panics occurred regularly. Yet while those crises routinely walloped business activity, crypto’s has largely passed the economy by.
Some investors, from unsophisticated individuals to big venture-capital and pension funds, have sustained losses, some life-changing. But these are qualitatively different from the sorts of losses that threaten the solvency of major lending institutions and the broader financial system’s stability.
To be sure, some loan or investment losses by banks can’t be ruled out. Banks also supply crypto companies with custodial and payment services and hold their cash, such as to back stablecoins. Some small banks that cater to crypto companies have been buffeted by large outflows of deposits.
Traditional finance had little incentive to build connections to crypto because, unlike government bonds or mortgages or commercial loans or even derivatives, crypto played no role in the real economy. It’s largely been shunned as a means of payment except where untraceability is paramount, such as money laundering and ransomware. Much-hyped crypto innovations such as stablecoins and DeFi, a sort of automated exchange, mostly facilitate speculation in crypto rather than useful economic activity.
Crypto’s grubby reputation repelled mainstream financiers like Warren Buffett and JPMorgan Chase & Co. Chief Executive Jamie Dimon, and made regulators deeply skittish about bank involvement. In time this was bound to change, not because crypto was becoming useful but because it was generating so much profit for speculators and their supporting ecosystem.
Several banks have made private-equity investments in crypto companies and many including J.P. Morgan are investing in blockchain, the distributed ledger technology underlying cryptocurrencies. A flood of crypto lobbying money was prodding Congress to create a regulatory framework under which crypto, having failed as an alternative to the dollar, could become a riskier, less regulated alternative to equities.
Now, stained by bankruptcy and scandal, cryptocurrency will have to wait longer—perhaps forever—to be fully embraced by traditional banking. An end to banking crises required the replacement of private currencies with a single national dollar, the creation of the Federal Reserve as lender of last resort, deposit insurance and comprehensive regulation.
It isn’t clear, though, that the same recipe should be applied to crypto: Effective regulation would eliminate much of the efficiency and anonymity that explain its appeal. And while the U.S. economy clearly needed a stable banking system and currency, it will do just fine without crypto.
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