ETF Insight: Weighing up the true costs of ESG

Scott Longley

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It is a central tenet that ESG investment is popular with investors who are keen on attuning how they put their money to work with their wider beliefs, however, the extent to which there is a full understanding of how this is achieved and what might be the net effect are perhaps less well understood.

The debate around the efficacy of ESG investment roared back into life at the end of May with a report by Vincent Deluard, head of macroeconomic research at INTL FCStone, who suggested that ESG investment was an unwitting ‘jobs killer’.

As Deluard admitted when he spoke to ETF Stream in the wake of the publicity his findings garnered, even he was surprised by the level of coverage he received for his argument that ESG funds tend to overweight in relatively jobs-lite technology and healthcare stocks while swerving many much more employee-intensive sectors.

Deluard wrote: “ESG filters unintendedly reward the greatest illnesses of post-industrial societies: winner-take-all capitalism, monopolistic concentration, and the disappearance of jobs for normal people.”

But Mark Northway, investment manager at Sparrows Capital, argued such an “anomaly” is in part caused by the “immaturity of ESG scoring mechanisms”.

As has been detailed previously on ETF Stream, there are long-standing arguments over the lack of consensus in ESG filtering. Northway pointed to research from Dimson, Marsh and Staunton in the recent Credit Suisse Investment Yearbook which showed a wide dispersion of ratings from the major providers on six big US-listed firms.

“ESG ratings are still a very blunt tool and open to manipulation by issuers,” Northway said. “Even when standards begin to converge this is an area in which subjective assessment and tick boxes will forge an uneasy coexistence.”

“It is not so much the particular exclusions that an index/ETF has but the naming itself,” Irene Bauer, chief investment officer at Twenty20 Investments, said. “We have SRI, ESG, ESG leaders, ESG trends and many other ESG naming conventions that actually mean very different things.

“The name does not tell you how high it tries to score on the ESG conviction front and you cannot expect a retail investor to go through all the factsheets and index methodology papers to determine that.”

In such circumstances impact in the boardroom is similarly hard to assess although a recent report from analysts at Scientific Beta did make the point there are reasons to suggest that both engagement and divestment do have an effect.

In the case of divestment, it “contributes to raising the cost of capital for divested companies” and that this gives their management “an incentive to improve their ESG performance”.

Meanwhile, on the engagement side of the equation if it is “properly managed and executed” it can contribute to a company’s ESG performance.

Still, up until recently, it was hard to claim either form of investment truly had an impact unless, as he said, “a big controversy arose,” Timo Pfeiffer, chief markets officer at Solactive, suggested.

“This attitude is now changing rapidly because of both investors' demands into active decision making and regulatory requirements,” he added. “There is no doubt that engagement and active proxy voting will increase substantially across both the ETF industry and the traditional mutual fund industry.”

Too much E and not enough S

Until now much of the emphasis has been on the environmental element – the E in the ESG three-piece-suite – and this, Deluard suggested, might be the cause of some of the distortion when it comes to jobs.

“Really the E has been the bigger part of the focus and the S and the G were added later,” he said. “So really it is all about climate change. But then to appeal to pension funds in Europe, they added the S and the G but obviously there is a conflict between the environment and humans.”

He suggested this bias can be corrected by extending the concept of best-in-class and providing what he calls a “compensation mechanism”.

“What I would favour would be the number of employees as a criteria of the S,” he added. “To represent the fact that a job is better than no job. I would put a premium from an ESG perspective for those that provide jobs.”

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Pfeiffer said this best-in-class approach will come to the fore in ESG implementation as it evolves with “clear and cohesive” strategies developing on how to tackle ESG-related topics such as “labour rights or the tackling of climate change”.

“It is for us as people to define what we would prefer from the social part of ESG,” Bauer continued. “Should there be an additional ‘keeping more workers than average’ component in the scoring system?”

Northway concluded that the unintended consequences of current ESG investment strategies such as the focus on companies with high market capitalisations per employee “may surprise investors.”

But the very fact that Deluard’s findings have garnered such press may prompt institutional investors to engage with ESG rating agencies to increase their scoring for job creation and employee satisfaction.

“This kind of fine-tuning is inevitable as responsible investing comes of age,” said Northway.

ETF Insight is a series brought to you by ETF Stream. Each week, we shine a light on the key issues from across the ETF industry, analysing and interpreting the latest trends in the space. For last week’s insight, click here.

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