New research reveals that environmental, social and governance (ESG) investing may not be as ethical as it seems. The same research also suggests that ESG investing could “sacrifice financial returns” without giving much in return.
Let’s take a closer look at the findings.
What is ESG investing?
ESG investing refers to the practice of choosing stocks for ethical reasons. This is in contrast to traditional investing. This is because when it comes to traditional investments, the main focus is usually on financial returns.
ESG stands for ‘Environmental, Social and Governance’. Let’s take a closer look at what each of these factors can cover.
- Environmental problems can be related to issues related to climate change, the use of renewable energy and green technologies.
- Social issues may cover fair treatment of employees, ethical supply chains, and levels of consumer protection.
- Governance Topics may involve issues related to business ethics or the level of transparency for shareholders.
Essentially, ESG investing could be considered the “option” for investors who want to use their wealth to benefit the greater good. Given the recent media coverage of ESG issues, it is an area that has seen rapid growth in recent years.
According to Columbia University, assets under management in global exchange-traded “sustainable” funds with ESG investment objectives totaled more than $2.7 trillion (£2.2 trillion) as of December 2021. Of these funds, 81% held its headquarters in Europe, including the United Kingdom. Meanwhile, 13% were based in the United States.
The same data suggests that $143bn (£109bn) of new capital flowed into ESG funds between September and December last year.
What did the research reveal about the problems with ESG investing?
You may not be surprised to learn that ESG investing can yield lower returns than traditional investing. After all, companies with strong ESG values are less likely to prioritize financial returns, or so one might think.
According to Sanjai Bhagat, Professor of Finance at the university of colorado, ESG investing typically offers below-standard returns. He points to a University of Chicago research paper that looks at the sustainability ratings of 20,000 mutual funds. The research highlighted that higher-rated ESG funds generally attracted more capital than funds with low ESG ratings. However, none of them outperformed the financial returns of the lowest-rated funds.
Perhaps most surprising was research by Bhagat’s own university that suggested some ESG funds might give the wrong impression by re-qualifying their ethical credentials. For example, looking at the record of 147 US-based ESG fund portfolios and 2,428 non-ESG portfolios, companies listed in ESG portfolios were often found to have a “worse track record of compliance labor and environmental.
ESG investing can ‘sacrifice financial returns’
Looking at the research, one could conclude that ESG investing may not be as ethical as it seems.
Additionally, we know that ESG funds often underperform financially compared to portfolios with lower ESG ratings. So if ESG investing is seen as an unreliable indicator of the ethical values of individual companies, it begs the question of whether it is a sector worth worrying about.
Professor Sanjai Bhagat echoes this summary. He explains: “The conclusion to be drawn from this evidence seems pretty clear: Funds that invest in companies that publicly embrace ESG sacrifice financial returns without gaining much, if anything, in terms of actually furthering ESG interests.”
Are you looking to invest? If you are interested in investing, in ethical sectors or otherwise, take a look at The Motley Fool’s top rated stock trading accounts. If you are an investment newbie, also take a look at our basic investment guide that can help you avoid common investment mistakes.
Are you worried if you are investing ethically? If so, check out our article that explains how to know if an investment is ethical.
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