OB Report
May 2022
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ESG Investing: It’s Complicated

Murray Leith By Murray Leith, CFA   Executive Vice President & Director, Investment Research

What is ESG investing? Almost one in four retail investors in the United States believes that ESG stands for “Earnings, Stock and Growth.” This revelation comes from a recent study conducted by the National Opinion Research Center and the FINRA Investor Education Foundation.1 Only 21% of the 1,228 people surveyed knew that ESG actually refers to Environmental, Social and Governance factors.

From our perspective, it’s not surprising that individual investors struggle to understand ESG investing. The ESG landscape is like the Wild West, with few rules and standards. It also means different things to different people, and the rating agencies that evaluate corporations on ESG factors have varied methodologies and often provide conflicting scores. Nonetheless, professionally managed assets with ESG mandates, such as mutual funds and ETFs, have swelled in popularity, largely because they are marketed on the basis that ESG investing delivers superior performance. While we generally agree with the premise that “doing good is good business,” as explained by Equity Analyst Stephen Boland in the March 2021 Odlum Brown Report, the conclusion doesn’t always hold true for investors. Popular strategies sometimes yield excessive valuations, which can undermine performance. Lately, investors are grappling with the devastation in Ukraine and debating whether it alters the relative importance of each individual ESG factor. What does one do when the E and the S are in direct conflict? (More on that later.) Not surprisingly, the discussion has intensified as ESG-oriented funds have underperformed the broader market indices in the first quarter of 2022.

Environmental, social and governance criteria are rightfully and increasingly important to society, and they have always been key considerations in Odlum Brown’s process of selecting securities for client accounts. We think like business owners, and believe in owning firms run by good corporate citizens. How a business treats its customers, employees, suppliers and community influences its competitive position, profitability and growth prospects. As such, ESG factors are integral to our due diligence, alongside traditional financial analysis, when considering investment opportunities.

Responsible or ESG investing is a complex and confusing subject, and it’s useful to have a base understanding of the three major approaches:

ESG Integration: This is the most widely used approach and the one employed by the Odlum Brown Research Department. It involves the assessment of material ESG risks and opportunities, alongside traditional financial analysis in the investment process.

Socially Responsible Investing (SRI): This entails negative screening or limiting the investment universe based on predetermined criteria. For some, it means not investing in areas like fossil fuels, tobacco or firearms. The approach aims to align investments with a specific set of values or beliefs.

Impact Investing: Investing in businesses that are trying to solve problems such as climate change, quality of education or poverty.

Our clients have varied ESG objectives, and we are able to tailor portfolios to their unique needs, constraints and preferences, as all accounts are fully segregated with individual securities and/or products. Our Investment Advisors and Portfolio Managers oversee these personalized client accounts and can incorporate one, two or all three of the common approaches to responsible investing, based on a client’s preferences.

In addition to our own analysis, we monitor insights from third-party rating agencies like MSCI, S&P Global Ratings and Morningstar’s Sustainalytics. While the outside research is valuable, one has to critically evaluate their conclusions. Companies will often receive a high ESG grade from one agency and a low mark from another. Studies have demonstrated that these inconsistencies are widespread. In a recent CFA Institute blog post titled “ESG Ratings: Navigating Through the Haze"2 Kevin Prall, Business Valuation Standards Director at the International Valuation Standards Council, looked at six separate ESG ratings providers for over 400 companies across 24 industries. After developing a scoring system to harmonize ratings across providers, Mr. Prall found an extremely low level of correlation. For instance, MSCI’s ESG ratings’ correlation with S&P Global’s and Sustainalytics’ was less than 36%. The correlation between S&P Global and Sustainalytics was higher at 65%, but still indicates significant discrepancies. For context, consider that the correlation of long-term debt ratings from the three big credit rating agencies – S&P Global, Moody’s and Fitch Ratings – for the same companies was approximately 95%. Calculating the likelihood that a company will repay its debt is clearly more of an exact science, whereas assessing ESG factors and assigning a grade involves a higher degree of subjectivity.

This doesn’t mean third-party research isn’t useful; it is. However, one has to appreciate that each provider uses different methodologies and factor weightings.

According to the Deloitte Center for Financial Services, professionally managed assets with ESG mandates swelled to $46 trillion in 2021, representing nearly 40% of all assets under management. The rising popularity of ESG funds has been fueled by impressive performance, yet critics argue that the industry has oversold this success. Critics contend that much of the superior performance over the last decade can be attributed to ESG funds’ tendency to overweight technology equities, which have outperformed, and underweight fossil fuel stocks, which have underperformed until recently. The war in Ukraine and rising inflation are benefiting energy stocks and are weighing on the valuations of technology stocks; as a result, ESG-focused funds are underperforming. Barron’s Magazine dramatically declared, “Sustainable Investing Failed Its First Big Test. A Reckoning is Coming"3 in its cover story on April 17, 2022. While the author, Lauren Foster, acknowledges that one quarter of poor performance does not constitute a trend, we wonder how, or whether, this investment strategy will evolve in response to changing sentiments.

The war in Ukraine is forcing investors to think more broadly about ESG factors. Climate change and environmental issues often take centre stage in ESG discussions, but there is a growing awareness of pressing social considerations. Fast-rising energy prices act like a tax on consumers, and low-income households are hurt disproportionately. That has caused governments to subsidize high energy prices by lowering fuel taxes and/or distributing money. Likewise, President Biden’s decision to release significant amounts of oil from the Strategic Petroleum Reserve runs counter to efforts to limit climate change. The E and the S in the ESG equation are in conflict with each other in this instance when thinking about climate change and inequality.

With Europe overly reliant on Russian oil and gas, there is an increased interest in accelerating the pursuit of secure sources of clean energy. At the same time, there is an elevated appreciation for access to fossil fuels from friendly sources in the West, to bridge the transition to a greener world. Many argue that Europe should buy Canadian oil and gas rather than finance Putin’s war efforts by buying them from Russia.  

Investors are also rethinking how the defense industry fits within the ESG context. Prior to Russia’s invasion of Ukraine, the general view was that such businesses didn’t belong in ESG-focused funds. After all, defense companies make products that kill people, and those products are often sold to bad actors. However, the world doesn’t look as secure as it did a couple of months ago, and defense spending is increasingly seen as a necessity to protect democracy.

ESG considerations are complex and nuanced, and the individual factors can conflict with one another. That is why there is so much variability in third-party ratings. It’s also why ESG discussions can be controversial. We will continue to apply a holistic approach to ESG considerations, and strive to deepen our understanding of the issues. Most importantly, we will work with our clients to structure portfolios that are suited to their individual perspectives and needs.

1 https://www.finrafoundation.org/sites/finrafoundation/files/Consumer-Insights-Money-and-Investing.pdf

2 https://blogs.cfainstitute.org/investor/2021/08/10/esg-ratings-navigating-through-the-haze/

3 https://www.barrons.com/articles/esg-investing-big-test-reckoning-51650041442?mod=past_editions (Subscription Only)

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