Pensions / Financial planning

Is ESG investing facing growing pains?

Investors continue to have a huge appetite for investing ethically, which has seen ESG funds become a very popular choice in recent years. Yet, with more interest comes increased scrutiny and it’s clear that not all ESG funds are created equal. In fact, some issues have recently come to light which have left the sector a little bruised. Ed Read Cutting, Director of our Belgium Office, details some of the challenges which ESG investing has experienced and how the sector looks set to respond.

Is ESG investing still popular?

ESG investing – which focuses on choosing funds which are classed as more socially responsible – remained a big draw for investors in 2022. The amount invested in these funds, known as global inflows, hit $33.9bn in Q2 2022. Although that figure dropped to $22.5bn in Q3 2022, it still bucked the trend seen in other areas during the same period where, on the whole, outflows were the name of the game. It also seems likely that the popularity of ESG investing will continue, especially given the significance (and regulation) of a net zero carbon focus for companies and governments.

Increased scrutiny of ESG

As this area of investing matures there are bound to be some bumps in the road. Throughout 2022, criticism of ESG investing certainly picked up with accusations of greenwashing, anti-woke behaviour and the transparency of fund manager activity.

The result was for relevant authorities to begin to take a closer look at the way the sector is handling itself. Two high profile events in the US and Germany saw Goldman Sachs accused of issues with the credibility of its ESG research, and DWS exposed by a whistle-blower for errors in its ESG strategy and possible prospectus fraud.

All this starts to chip away at the very foundation of this sector – a somewhat ironic situation for those who have actively sort out a more principled approach to investing! On a serious note, these events of course generate concern and negative publicity for ESG investing. Some of the criticisms levelled more generally are the use of vague jargon, homogenous disclosures from companies about their ESG practices and a lack of comparability – which makes it difficult to assess the ESG credentials of fund choices. Other concerns involve the behaviour of the sector itself, with the carbon footprints of some of the largest asset managers deemed particularly questionable.

There’s been some quick reaction, particularly in the US where ten states have implemented anti-ESG regulations to stop public pensions plans and government bodies avoid providers who themselves are turning their back on sectors based on their ESG credentials. A real-life example of this is that many ESG funds now avoid fossil fuels for climate-based reasons, but it could be argued that these businesses will help ease the energy crisis in the short term.

Current challenges

It’s certainly a challenging time, and tighter regulation is coming. Over the long term this will certainly help investors but in the short term can feel a little confusing. And with different regulators operating in different areas there’s still no universal approach to how ESG practices are measured. A lack of corporate data also makes it that much more difficult to determine the trustworthiness of a company’s ESG activities. We’re seeing some other shifts in the sector, where funds are being reclassified – notably from dark green (where sustainable investing is the core focus) to light green (where sustainable investing isn’t the focus, but still important). So it’s fair to say we’re in a state of flux and the goalposts are shifting. New rules are coming and one to watch is the SEC (the US body which protects investors and maintains fair, orderly, and efficient markets) who’ll be updating their regulations early this year.

Does ESG investing have a positive impact?

It’s still a little uncertain whether ESG has a positive impact – in reality both sides of the argument have merit. ESG funds do favour firms with lower pollution, more board diversity, higher employee satisfaction and better workplace safety, but these organisations don’t seem to be fundamentally changing their behaviours – yet.

In terms of performance, last year saw ESG investments suffer more than non-ESG investments. In particular, funds which targeted sustainable investment or considered environmental and social characteristics did less well than funds which didn’t incorporate any kind of sustainability into their investment process. Despite all this, 2022 can still be considered a positive one for ESG investors; it certainly made expectations around ESG investing much more realistic. Before then ESG investments had gained momentum with the strong rally of growth stocks being the driving factor. The conflict in Ukraine and global economic conditions of high inflation and increasing interest rates saw a move out of growth stocks into value, which impacted ESG funds given they typically do less well in this environment. Nevertheless, the year, although tough, still demonstrated the positive impact these funds can offer investors.

What’s next for ESG investing?

ESG investing will continue to be of interest to many investors. And greater transparency ultimately means that steps are being taken to re-establish confidence in the sector. This area of investing has a great deal of potential and remains a strong area for many investors to consider, but let’s not forget that it’s still in relative infancy. Growing pains are just part of the process.

To discuss ESG investing, or any aspect of your investment strategy, please contact your nearest office.