by Amanda Vaught, email@example.com
Some may be eager to sound the death knell for ESG investing, but for now, they are jumping the gun.
There are many critics of ESG investing. Take, for example, the below Twitter post. The author posts a chart comparing recent stock performance of fossil fuel companies to the broader large cap ESG index.
There are a lot of misconceptions about ESG out there, and this Twitter post offers a great example.
In general, ESG refers to an approach to investing that incorporates three factors: Environmental, Social, and Governance when evaluating an investment. For more background on ESG investing, see my blog post, “Social Values Investing: A Propel Primer”.
What is going on with this graph?
This Twitter post states, “When wishful thinking meets reality.” It then shares a performance graph of fossil fuels (illustrated by the S&P 500 energy index) versus ESG stocks (illustrated here by the S&P 500 ESG index). The poster hopes to make the point that ESG outperformance won’t hold up now that fossil fuel stocks have made incredible gains over the past year.
He is not alone. Many critics of ESG investing assert that the approach is just a recent fad that has benefitted from the momentum of investors piling onto this strategy. A second criticism argues that many ESG products are just marketing fluff, and there’s no substance to it. Finally, and in line with the twitter post above, critics argue that ESG’s recent outperformance is because ESG funds are anti-fossil fuels.
Response to criticisms of ESG investing
So, who’s right? Does ESG outperform or is it all just a sales tactic? As with any investment approach advocated by various people, usually the answer lies somewhere in the middle. I’ll respond to three major criticisms of ESG investing below:
1. Recent fad
The ESG approach to investing has been around for decades. Recently, it gained more traction in Europe as more investors demanded more “green.” With the European demand, American investment companies created investment products to sell to customers. Eventually, demand picked up in the US; and over the past 3 years, ESG funds have seen record inflows. So yes, it’s true that many more investment products tout themselves as ESG now than in years past, but the ESG approach to investing has been around for decades.
We agree that there is a lot of marketing fluff around ESG, but that doesn’t necessarily negate the underlying strategy. Understanding the fundamental approach to ESG helps an investor to separate the wheat from the marketing chaff. That is true of all sales gimmicks in the industry.
3. Intersection of fossil fuels and ESG index investing
First, let’s clarify that there is a significant difference between divestment and ESG investing.
Divestment is a social values-approach to investing that involves actively eliminating a certain company, or category of companies, from an investment portfolio.
Many environmentalists advocate for the divestment of fossil fuel companies from pension funds, endowments, and other institutional investments. Meanwhile, critics of ESG conflate it with a divestment approach, as both ESG and divestment fall under the “social values investing” umbrella. Some funds do take a combined approach, and mix divestment with ESG investing, but not all.
If you attended my recent webinar, “Celebrate Earth Day Every Day in Your Investment Portfolio” , you know that true ESG analysis is really about evaluating qualitative characteristics of a company in a broader context, based on its social and governance characteristics in addition to its environmental ones.
Any fossil fuel, oil or gas company can be evaluated through an ESG lens. Many practitioners of the ESG approach think the “G” factor, or governance, is the most important when looking at the qualitative factors of a company. Just because “ESG” contains the word “environment” does not mean that it is an environmentally-friendly approach to investing.
Many misconceptions around ESG relate to the methodology behind ESG scores. The ratings companies make judgments on risks and accordingly assign different weights to different factors. The companies who give out ESG scores do not always consider the absolute values on an environmental score, but are often considered relative to their competitors. Further, in many instances, the score is based on a company making changes.
For example, consider a chemical company that has been polluting a waterway for years. Now, the chemical company discloses this past pollution, but reveals that they have been making changes in their approach to the environment and their responsibility for its clean up. The company begins an initiative to change its internal procedures to dispose of waste responsibly.
Is the company a bad polluter and, therefore, bad for the environment? Yes. With that logic, you might assume that they would earn a bad score for their pollution history. Not so. In this example, the ESG raters give them high marks as they’ve been making proactive strides to clean up their act, thereby, reducing their risk. (Read more on ESG scoring methodology)
ESG adherents would argue that while the company’s balance sheet may take a hit in the short-term to pay for these initiatives, they are now a more valuable company. In the long-term, customers will be more likely to be loyal to them; their brand won’t suffer from bad press relating to pollution; and they won’t be subject to lawsuit judgments that hurt their bottom line.
This is the one big caveat when looking at ESG indexes: Companies are assigned scores from ratings agencies. The scores are inconsistent and don’t necessarily reflect a true reading of the company’s behaviors in regards to these factors. Many proposals are on the table for the SEC to regulate ESG standards and company disclosures around ESG. Until that happens, we must solely rely on what companies choose to share.
So what is the problem with the comparison in the above graph?
First, the poster seems to assume that ESG investing is the same as divesting. Comparing the S&P 500 ESG Index to the S&P Energy Sector Index, is like comparing apples to oranges. The S&P 500 ESG Index is simply a group of the existing S&P 500 companies with the highest ESG scores, and it includes all sectors of the large cap stock market. At any point in time, one sector of the market is going to be outperforming (or underperforming) the rest of the market.
Second, ESG is not a short-term investing strategy. The thesis of an ESG approach is that over time the factors of “E”, “S”, and “G” will give companies advantages to outperform. Short-term swings in the market (Recently, the geopolitical and humanitarian crisis of Russia invading Ukraine caused spikes in the price of oil.) cause short-term volatility that ultimately evens out when we look at the market with a longer time horizon.
So why is the author using a chart showing short-term performance?
The posted chart shows performance since December 31, 2020. Why did he choose that date? One potential reason is that the end of 2020 was one of the lowest points for energy stocks we’ve seen in decades. Therefore, showing performance since that time is going to skew the chart to show a larger outperformance by the energy sector.
What if we took the same comparison, but lengthened the timeline?
The S&P 500 ESG Index was first created on January 28, 2019, so the longest performance comparison we have is three years. In those three years, through the end of April 2022, the ESG index produced a total return of 55.4% vs 34.7% for the energy sector - a spread of more than 20%.
Past performance is no guarantee of future returns.
As you can see, over the past three years the returns from the energy sector (purple line) fall far short of those of the S&P ESG Index (orange line). Just zooming out gives you a little different picture of things than the one graph shared on Twitter!
But still, we are comparing apples and oranges.
Compare apples to apples
A better comparison is this:
If we want to isolate the potential benefit of the ESG factor for companies, let’s isolate that variable and then compare.
First, I looked at the Xtrackers S&P 500 ESG ETF (SNPE) from DWS. In this ETF, DWS tracks the S&P 500 ESG Index. Essentially, it starts with the universe of S&P 500 companies, and then screens for the companies with the highest ESG scores within each sector that comprises the S&P 500 Index.
As of May 2, 2022, the 19 companies in the energy sector with the top ESG scores (according to this index) were: Exxon, ConocoPhillips, EOG Resources, Schlumberger Ltd, Pioneer Natural Resources, Marathon Petroleum Corp, Occidental Petroleum Corp, Valero Energy Corp, Williams Companies Inc, Phillips 66, Devon Energy Corp, Kinder Morgan Inc, Halliburton Co, Hess Corp, Baker Hughes, Oneok Inc, Marathon Oil Corp, APA Corp, and Chevron Corp.
In the below graph, I created an equally-weighted index comprised solely of these top-scoring ESG companies within the energy sector. Then, if we compare this index against the broader group of companies in the energy sector, we have a better comparison of how the ESG factors are working within the energy sector.
As you can see, the highest ESG-rated companies outperform the broader energy sector by a significant margin.
Normalized total returns 4/30/2019 – 4/29/2022. Note that my index of energy ESG leaders is equal-weight, so I compared it to the equal-weighted S&P energy sector index. Past performance is no guarantee of future returns.
Now we have a true apples-to-apples comparison where we only altered one variable: one group represents all energy stocks and the other group is all energy stocks filtered by the highest ESG ratings. Now we can see that the companies with higher ESG scores within the energy sector outperform the broader energy sector 58.9% vs 40.3% over the last three years.
But what if we take this apples-to-apples comparison and shorten the time-frame, as the original Twitter poster did?
Normalized returns since 12/31/2020. Past performance is no guarantee of future returns.
Now we see a true comparison of recent performance of ESG Leaders in energy versus the broader energy sector. From 12/31/2020 through 04/30/2022, the energy companies with higher ESG scores still outperform the energy sector by more than 3%.
Now that we have this apples-to-apples comparison, the assertion that ESG is a flawed strategy falls apart. Recent performance, in fact, shows the opposite.
Ask yourself, why would the Twitter-poster not use a chart like the one above? Beware of sources that cherry-pick data to fit their agenda.
In closing, while some may be eager to sound the death knell for ESG investing, we at Propel believe they are jumping the gun. ESG is a thoughtful and data-driven approach that Propel employs when creating a portfolio for its owners and clients. We want companies that are responsible to their communities and who look ahead to future growth, rather than short-term stock valuations. For more information, please reach out to firstname.lastname@example.org.