An Evidence-Based Approach to ESG Investing, Part 2: How Do We Measure “Good”?

As was covered recently, environmental, social, governance (ESG) investing is a relatively new approach for investing “ethically,” however you define the term. Some ESG investors may be more values-driven, hoping to best align their investments with their personal beliefs. Others are more value-driven, hoping for higher returns by investing in companies whose sound ESG practices are expected to generate better outcomes.

To varying degrees, investors are increasingly seeking a combination of both:

• A 2018 Global Sustainable Investment Alliance review cited investor demand as the leading motivation for sustainable investing.
• Morningstar reports the number of sustainable index funds and dollars invested in them have more than doubled in the past three years. As of June 30, 2020, there were more than 500 sustainable index funds managing more than $250 billion around the world.
• In December 2020, The Wall Street Journal reported that investors had added a record $27.4 billion into U.S. ESG ETFs alone for the year.
• US SIF (The Forum for Sustainable and Responsible Investment) reported in its 13th edition of the Report on US Sustainable and Impact Investing Trends on November 16, 2020 that sustainable investing assets have grown to $17.1 trillion, a 40% increase since 2018.

How Do You Quantify a Quality?

All well and good, but how do we ensure there’s real substance behind the popular appeal? Along with the rise of “green” investing, “greenwashed” investments are sprouting up like weeds. They may claim to be ESG-focused, but a closer look might reveal otherwise.

Academics and practitioners alike are still working on this triple riddle:

1. Data: How do we compel or cajole companies into reporting meaningful ESG data?
2. Ratings: How do we consistently compare and score companies’ ESG data?
3. Application: How do we incorporate ratings into an evidence-based investment strategy?

Differing Data Standards

Arguably the greatest challenge in this still-nascent field is gathering the data needed to measure corporate “goodness.” In a BNP Paribas 2019 ESG Global Survey of institutional investors, participants cited “inconsistent quality of data” as the greatest challenge to ESG investing. As one survey participant commented, “There is lots of data. The challenge is finding the right data in the right format and knowing how to use it.”

At least three hurdles exist:

1. Three Balls to Juggle: First, remember, “ESG” isn’t one thing – it’s three. Governance data has been around the longest, so it’s the most robust. According to the aforementioned survey, generating better corporate environmental and social data is “a key part of the data challenge.” Plus, a company’s overall ESG rating can vary widely, depending on how much weight each component has in the total score.
2. Missing Pieces: Most corporate data reporting remains voluntary. Some requirements are coming into focus. Countries, like the U.K., are beginning to require specific data reporting. Plus, activist shareholders are increasingly calling for more robust ESG reporting from the companies they’re invested in. Things are changing, but, for now, companies often have wide leeway on what ESG data they choose to report, and how they choose to report it.
3. He Said, She Said: Multiple data providers produce different, sometimes conflicting data. A 2020 Research Affiliates report identified 70 different firms that create or curate ESG ratings data (not including untold numbers of private, one-off, or customized data sets). Each firm may adhere to different standards, or even its own secret sauce. In an August 2020 report, Buckingham Strategic Partners’ director of research Larry Swedroe cited a host of new studies showing “the major firms that issue ESG ratings use sufficiently different criteria, which results in unreliable research findings when their databases are used.”

Gathering dependable data is a challenge for any evidence-based investment approach, but it can be especially daunting when an approach is relatively new and advancing faster than best practices can keep pace with. Bottom line, strong, time-tested data reporting standards remain a work in progress.

Rating Challenges

Once a company’s ESG data is obtained, the next step is to use it to score and rank their relative ESG performance.

For this, most investors depend on rating agencies. In its 2020 “Rate the Raters” report, SustainAbility counted more than 600 global ESG raters and rankers as of 2018. That number has grown since then, and each agency brings its own personality to the mix.

Research Affiliates describes three broad categories of ESG rating activities:

1. Fundamental: Some data providers specialize in curating publicly available data, without necessarily creating scores or ratings themselves; they leave that next step to others. Examples include Refinitiv (formerly Thomson-Reuters) and Bloomberg.
2. Comprehensive: A number of rating agencies combine public data with their own analyses, interpretations, and rating methodologies to provide ratings as well as trend reports. Examples include veteran firms such as MSCI and Sustainalytics, as well as newer “algorithmic-focused” firms such as TruValue Labs and RepRisk.
3. Specialized: Some data providers specialize in a particular cause, such as human rights or gender diversity, to serve investors who want to prioritize particular issues.

Given the assorted reviews, a company’s ESG data may receive widely different positive or negative scores. It often depends on who is doing the rating, and what metrics, weightings, and priorities they’re using.

To illustrate, Research Affiliates took a look at Wells Fargo’s year-end 2017 ESG ratings. You may recall, this was a period when the company was in the thick of its notorious account-churning scandal. Two different rating agencies issued very different ESG scores at the time. On a best-to-worst scale of 1.0 to 0.0, one agency gave Wells Fargo an overall ESG score of 0.84; the other gave it a 0.31, in part due to widely divergent social and governance ratings.

Wells Fargo: One Company, Different Scores (as of 12/31/2017)

Research Affiliates, “What a Difference an ESG Ratings Provider Makes!” January 2020

It’s not necessarily bad or wrong for different rating companies to rank the same data differently, but the rich variation obligates (and allows) you to find a fit that’s right for you. In other words, if you wish to become an ESG investor, you and your advisor will want to understand what’s really behind different ratings, so you can be selective about which investments best align with your own priorities, values, and goals.

Applying the Ratings

There’s one more avenue to explore. How do we balance an investor’s desire to invest “ethically” with our fiduciary duty to advise clients according to their highest financial interests?

The goal is simple enough: We’d like to achieve both. Existing studies and practical applications suggest we can. Just as we have standard benchmarks and indexes for other purposes (such as tracking U.S. large companies, global bonds, or emerging market real estate), providers have responded to public interest by offering a growing collection of ESG benchmarks for comparing one strategy to another.

That said, it's still early in the process. By definition, it takes years, if not decades, to determine whether evidence-based theories test out in reality – through bull and bear markets; here and abroad; and across stocks, bonds, and other asset classes. The reality is, evidence-based ESG investing is too new to have this sort of track record.

Where We Stand Today

All things considered, evidence to date suggests there are cost-effective solutions available if you would like to invest more sustainably while still pursuing efficient market returns.

But the same evidence informs us, not all ESG data, ratings, and strategies are created equally. Dimensional Fund Advisors offers a helpful perspective in its October 2020 paper, “The Economics of Climate Change.” While the paper focuses on environmental-related ratings, the conclusions apply broadly across ESG investing.

“Investors face voluminous and sometimes contradictory academic evidence,” the authors note, but, “simple, tried-and-true investing principles can help.” These principles include:

• Letting relatively efficient markets set the pricing (rather than chasing hot trends)
• Having well-defined investment goals
• Maintaining broad diversification

Whether you’re investing in ESG or traditional funds, these remain the enduring keys to a successful investment experience. They are the touchstones for navigating the uncertainty inherent in any fast-moving trend.

So, yes, ESG investment challenges remain – and probably always will. That’s where Escient Financial can assist: to help you clearly define your highest financial goals in the context of your personal values. By positioning you to compare and contrast the practical costs and benefits involved, you can invest in the right ESG solution for you. Whether you’d like to get started right away, or simply remain informed, Escient Financial is standing by, ready to respond. Feel free to...