New research shows that mutual funds and ETFs with an environmental, social and governance (ESG) mandate failed to live up to their promises. Those funds, for example, had worse track records for compliance with labor and environmental laws and were less likely to voluntarily disclose emissions data than non-ESG investments.
For the fifth calendar year in a row, sustainable funds set an annual record for net flows: Flows reached $51.1 billion, with $20.5 billion of that coming in the fourth quarter.
The asset management industry has responded to the dramatic increase in demand for ESG investing in recent years by launching a host of “socially responsible” funds that at least nominally account for issues considered important to a business’s overall sustainability: the environment (e.g., carbon emissions), social issues (e.g., employee treatment) and governance (e.g., executive compensation). Morningstar reported that by the end of 2020, the group of sustainable open-end funds and exchange-traded funds available to U.S. investors numbered 392, up 30% from 2019 and a nearly fourfold increase over the past 10 years, with significant growth beginning in 2015.
The SEC takes notice
In March 2021, the Securities and Exchange Commission (SEC) created a new Climate and ESG Task Force to proactively identify misconduct related to ESG issues. The creation of this task force was driven by regulatory concerns that ESG funds are not providing asset owners with products that reflect concern for stakeholder welfare. In April 2021, the SEC stated that it had identified several asset managers that were misleading investors by marketing funds as ESG-friendly but not making investment decisions consistent with such marketing. They also identified some cases where funds did not even have a mechanism to “reasonably track” or screen portfolio firms’ ESG performance. Such cases raise concerns about “greenwashing” – the process of conveying a false impression or providing misleading information about how a company's products are more environmentally sound.
The evidence
Aneesh Raghunandan and Shivaram Rajgopal, authors of the April 2021 paper, “Do ESG Funds Make Stakeholder-Friendly Investments?” attempted to verify whether ESG-oriented funds’ claims of picking portfolio firms that exhibit superior treatment of all stakeholders (as opposed to shareholder primacy), are borne out by the evidence. They focused on whether self-labeled ESG-oriented mutual funds invest in firms that have better track records with consumers, employees, the environment, taxpayers and shareholders. They assessed firms’ track records with respect to these groups of stakeholders based on fundamental measures of behavior, or misbehavior, toward each group. Their primary measure of stakeholder-centric behavior was compliance with social (e.g., labor or consumer protection) and environmental laws. They also considered a host of other measures of stakeholder-centric behavior related to “E,” “S” and “G” distinctively: carbon emissions, reliance on taxpayer-funded corporate subsidies, CEO compensation, board composition and the balance of power between management and the shareholder.
Their tests centered on four primary types of stakeholder treatment measures: (1) comprehensive federal enforcement records pertaining to firms’ (mis)treatment of the environment, employees and consumers; (2) the extent to which they are actually “green,” measured using data on carbon emissions; (3) key features of their corporate governance structure; and (4) the extent to which firms impose costs on local taxpayers via their reliance on subsidies and other forms of regulatory support. They also addressed fund-level issues, including management fees and financial performance.
Raghunandan and Rajgopal limited their study to funds issued by financial institutions that also issued at least one non-ESG fund in the same year, and they compared ESG funds to non-ESG funds managed by the same financial institutions in the same year. They identified 147 distinct mutual funds over the period 2010-2018 that claimed to be ESG-oriented. They then tracked the stakeholder-related behavior of stocks included in and added to these funds relative to stocks held by 2,428 non-ESG funds run by the same financial institution-years. Following is a summary of their findings:
- ESG funds held portfolio firms with worse track records for compliance with labor and environmental laws relative to portfolio firms held by non-ESG funds managed by the same financial institutions in the same years – ESG funds’ portfolio firms have significantly more violations of labor and environmental laws and pay more in fines for these violations relative to non-ESG funds issued by the same financial institutions in the same years.
- Relative to other funds offered by the same asset managers in the same years, ESG funds held stocks that were more likely to voluntarily disclose carbon emissions performance but also stocks with higher carbon emissions per unit of revenue – ESG funds’ portfolio firms, on average, exhibited worse performance with respect to carbon emissions in terms of both raw emissions output and emissions intensity (i.e., CO2 emissions per unit of revenue), and average penalties for environmental violations are higher.
- ESG funds were more likely to pick stocks that voluntarily disclose emissions – companies with good ESG data are more likely to disclose these data in order to appeal to the small subset of investors who demand ESG data; at the same time, however, firms with poor or no ESG data were likely to be shunned by those investors who are motivated by ESG considerations.
Consistent with prior research (“The Influence of Firm Size on the ESG Score: Corporate Sustainability Ratings Under Review” and “ESG Performance and Disclosure: A Cross-Country Analysis”), ESG scores, which appear to be based on news-driven coverage of ESG, did not appear to correlate well with the actual contents of the firms’ voluntary disclosures.
Their findings led Raghunandan and Rajgopal to conclude: “Our findings suggest that socially responsible funds do not appear to follow through on proclamations of concerns for stakeholders.” They noted: “Our results raise questions about what exactly the purchasers of shares in self-labelled ESG or ‘socially responsible’ mutual funds are getting in exchange for this higher management fee.” They added: “A key takeaway of our study is that asset managers do not necessarily ‘walk the talk.’” Their findings are supported by the SEC’s April 2021 ESG Risk Alert in which the SEC specifically highlighted “overreliance on composite ESG scores as a sign of inadequate due diligence and of poor fund-level compliance more generally. The SEC’s bulletin emphasizes the need to understand whether ESG funds that claim to incorporate specific environmental or social factors into portfolio allocation decisions actually pick stocks that obtain superior performance with respect to these stated factors.”
The takeaway for investors is that before investing in an ESG fund, a high level of due diligence is required to verify claims of picking stakeholder-friendly stocks. Another takeaway, one regulators should consider, is that sufficient demand for the securities of high-quality ESG companies by a large number of institutional investors could create a situation in which companies are forced to disclose ESG information regardless of its quality. Consequently, average ESG quality would improve over time as companies vie to attract widespread investor interest in their securities (to minimize their cost of capital).
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
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New research shows that mutual funds and ETFs with an environmental, social and governance (ESG) mandate failed to live up to their promises. Those funds, for example, had worse track records for compliance with labor and environmental laws and were less likely to voluntarily disclose emissions data than non-ESG investments.
