Virtue’s Vice

Phil Kernen

IT’S BEEN A GREAT stretch for many mutual funds and exchange-traded funds that buy stocks based on environmental, social and governance (ESG) criteria. For instance, the actively managed Parnassus Core Equity Fund notched 19.3% a year over the three years through March 31, Fidelity U.S. Sustainability Index Fund has climbed 17.4% and iShares ESG Aware MSCI USA ETF 18.2%. All three funds look like winners compared to the S&P 500’s 16.8% annual total return.

Such results suggest you can do good and do well at the same—and investors have responded by showering ESG funds with money. But are past results a good guide to the future? It’s an open question whether the strong performance has been a luxury granted by a generally rising market, one that’s favored the growth stocks that many ESG funds own.

Today’s ESG investing is based on the view that how companies, say, respond to climate change, treat their workers and conduct their governance can positively impact their financial performance. That viewpoint grew out of—but is slightly different from—the earlier trend toward socially responsible investing (SRI). The latter has been practiced for decades and considers the environmental and social effects of investing and typically manifests itself in negative restrictions, such as no alcohol, tobacco or weapons companies. In effect, ESG investing rests on a financial argument, while SRI is more about a moral preference.

ESG investing, which is often traced to a United Nations initiative begun in the early 2000s, has grown rapidly over the past decade. The U.S. Sustainable Investing Foundation estimates that 25% of professionally managed assets now incorporate ESG criteria in their decision-making. As investors began paying more attention to ESG factors, they turned to ESG ratings agencies, which assemble data and produce ESG scores. But the challenges are numerous.

First, there are no agreed-upon standards for ESG disclosures. Each company can make its own assessment of what and how to disclose. Second, there’s no auditing process to verify the reported data. Third, there’s no common framework for ESG ratings. Each rating agency model is unique in terms of data inputs and weights applied. That means any one company’s rating can vary widely across agencies. Contrast this with the credit rating agencies, whose ratings are far more consistent for any given company, thanks to relatively exacting financial reporting standards. Put simply, ESG ratings are highly, highly subjective and the predictive nature of ESG scores should be viewed with healthy skepticism.

Most investors would agree with the concepts behind ESG investing. In theory, companies that prioritize ESG values are more likely to thrive than those that don’t. A business may make huge profits in the here and now, but if doing so results in them polluting their communities, mistreating their workers and fostering a toxic culture, those profits could quickly slip away.

Still, we shouldn’t put the cart before the horse. A company with strong ESG characteristics that reports weak cash flow, is run by an ineffective management team or holds little prospect for growth will be a bad investment any day. Ditto for a company with strong ESG ratings whose stock is wildly overpriced. If you’re actively managing a portfolio, it’s important to put the business and financial analysis first. Positive ESG factors are the icing on the cake.

Phil Kernen, CFA, is a portfolio manager and partner with Mitchell Capital, a financial planning and investment management firm in Leawood, Kansas. When he’s not working, Phil enjoys spending time with his family and friends, reading, hiking and riding his bike. You can connect with Phil via LinkedIn. His previous articles were Staying SafeWe’re All Active and What? Spend It?

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