Is There Truth In Advertising Of ESG Funds?

Transparency about financial products is as important as transparency for physical products

The firing of Desiree Fixler, the Global Sustainability Officer, from the large asset management firm, DWS, has re-focused attention on the plumbing underlying the ESG-ness of the investment industry. My co-author, Bob Eccles, collaborated with Ms. Fixler to develop the three principles developed by the Financial Conduct Authority (FCA) that an asset manager should follow while designing ESG funds: (i) description of the investment strategy including the investible universe, screening criteria, specific ESG impacts pursued, relation to indexes, the stewardship activities of the fund; (ii) ESG integration, ESG data used, whether holdings match the stated mission; and (iii) does the fund walk the talk via published KPIs (key performance indicators)?

A couple of years ago, my co-author Aneesh Raghunandan and I, in a paper called, “Do ESG Funds Make Stakeholder-Friendly Investments?” set out to verify whether the self-labeled ESG funds were really stakeholder-oriented or not using a set of first principles. We came up with a set of simple questions related to the specific stocks held by these self-labeled ESG funds:

·      Does the company have a favorable “rap sheet” with environmental and labor regulators?

·      Does the company disclose carbon emissions data?

·      Are the company’s carbon emissions as a proportion of revenue relatively low?

·      Does the company attract more than average subsidies from the state and does it spend more than average on lobbying rule makers?

·      Does the company’s CEO earn abnormally high compensation?

·      Is the management of the company more entrenched?

We uncovered several interesting observations. On average, self-labeled ESG funds pick companies with worse employee treatment and environmental practices than non-ESG funds, as per the rap sheet with regulators. Stocks in ESG funds rely more on government subsidies and lobbying. While ESG funds’ portfolio companies are more likely to voluntarily disclose emissions, on average, these companies exhibit 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). Remarkably, ESG ratings for the stocks hold by these funds are uniformly high. To top it all, ESG funds obtain lower stock returns relative to well-known determinants of such returns but charge higher management fees.

Bob Eccles’ micro approach complements nicely with the macro approach that Aneesh and I use to show that ESG funds, on average, did not walk the talk. Abstract statistics are great for an academic audience but never really resonate with other stakeholders. To bridge that gap, consider a random example. The annual report of John Hancock’s ESG International Equity Fund (ticker: JTQRX) for the year ended October 31, 2020 uses the term “ESG” 52 times. Almost all of these references relate to the brand name of the fund. The word “sustainability” appears once. 

Their prospectus states

“the manager seeks to identify companies with a demonstrated overall high level of accountability to all stakeholders, including providing safe, desirable, high-quality products or services and marketing them in responsible ways. ESG criteria reflect a variety of key sustainability issues that can influence company risks and opportunities and span a range of metrics including board diversity, climate change policies, water management policies, and supply chain and human rights policies. The fund will avoid investments that in the judgment of the manager have material direct revenues from production of nuclear power, tobacco, and/or weapons/firearms. The manager employs active shareowner engagement to raise environmental, social, and governance issues with the management of select portfolio companies. Through this effort, the manager seeks to encourage company managements toward greater transparency, accountability, disclosure, and commitment to ESG issues.”

Let us unpack these statements. The screening criteria are clearly laid out, but the criteria are remarkably silent about exclusions related to fossil fuels such as coal or oil. We could debate whether screening out nuclear power is really productive if the goal is to cut carbon emissions. However, I could not find much of a discussion of how the fund makes sure that stakeholders provide “safe, desirable, high-quality products or services and marketing them in responsible ways.” How does the fund assess “board diversity, climate change policies, water management policies, and supply chain and human rights policies?” It is also not obvious how the fund encourages managements towards greater transparency and accountability. The fund does not explicitly state that they rely on ESG rating agencies. But if they don’t use ratings, then what do they rely on? If they use ratings, do we know whether the rating covers the issues the fund cares about? And how are these diverse factors such as board diversity or supply chain responsibility weighted and aggregated?

For another random example, consider the ishares ESG ETF (ESGD), managed by BlackRock. Their prospectus uses the term “ESG” 62 times and again mostly in the context of the brand of the fund. They state explicitly that their ETF relies on MSCI’s ratings of social responsibility. So, the question of stakeholder orientation gets delegated to MSCI’s judgement. How does an investor validate these ratings? 

As a small window into their thinking, consider the MSCI USA ESG Leaders Index which lists its top picks as Microsoft, Alphabet, Tesla, Nvidia, Johnson and Johnson, Visa, Home Depot, Procter and Gamble, and Disney. As per Good Jobs First, an NGO focused on corporate accountability, since 2000, Microsoft has paid penalties of $335 million, Alphabet has paid $875 million, Tesla $82 million in its brief life so far, Johnson and Johnson of $9.2 billion, and Home Depot of $182 million.  Visa, Nvidia, Disney and Procter and Gamble have a relatively clean rap sheet with federal and state regulators.

Emissions data are voluntarily disclosed by all of these companies except for Disney that does not disclose Scope 3 emissions and Tesla that remarkably discloses nothing at the enterprise level. Tesla reports instead a lifecycle analysis of the emissions for a Fremont-made Model 3 in their sustainability report. 

Assigning a charge of $100 per ton of carbon emissions (scope 1,2 and 3) to these companies’ net income for the last year can be revealing. Tesla and Disney reported losses last year. Procter and Gamble’s last year’s profits of $13 billion would be wiped out with a carbon charge of $19.6 billion because of its massive scope 3 emissions. Visa would lose 0.03% of its net income relative to Microsoft which would lose 10.3% of its net income to a carbon charge.

A look at subsidies handed out by state and federal government is interesting. Microsoft has received $807 million since 2000, Alphabet $923 million, Tesla $2.5 billion and $466 million of loans, Johnson and Johnson $91 million, Home Depot of $94 million, Procter and Gamble $242 million, Disney $1.4 billion. I could not find disclosures that lays out the social benefits of these subsidies. Bottom line, how did MSCI consider and aggregate these data points?

So, as usual, caveat emptor when you buy ESG funds. I have made this point earlier in the context of labels in the world of investing more broadly as investors increasingly buy baskets of stocks based on labels, not individual stocks themselves. Even then, given the complexity of the issues regarding language, ratings, and the use of ESG of many kinds, we need stronger regulation of ESG funds, by whatever name, so that the average investor really knows what she or he is buying. It is no different than product labels regarding ingredients and sourcing or notification of how many calories in a drink at Starbucks. Transparency about financial products is as important as transparency for physical products and consumables.