Signals: ESG is broken– how to fix it

Hey fintech friends,

ESG is turning out to be kind of a womp womp: Why do investors pay a 40% premium on fees for ESG funds versus traditional funds when these portfolios don't necessarily outperform the market? How come there's even evidence that these companies have worse track records for labor and environmental compliance than companies in non-ESG portfolios?

On that note, why is ExxonMobil one of the top 10 holdings in the S&P 500 ESG Index if it runs the highest-polluting oil refineries in the US? How come cigarette giant Phillip Morris has an S&P ESG score of 83, when Tesla's is only 37? What does an ESG score of "37" even mean?

We need to have a talk about ESG investing. ESG has been touted as a way for investors to promote corporate responsibility, in a world where companies are driven to action by movements in their stock price. It stands to reason that responsible corporate behavior drives better business performance, so shareholders– who in principle govern the companies they've invested in– should be pushing for this anyway.

In reality, the vehicles that most investors use to gain exposure to ESG are still principally designed to drive short-term returns, not to push companies to do more recycling (or whatever). There's even a credible argument to be made that ESG investment worsens a stock's financial performance by driving up volatility.

It doesn't have to be this way! Investing can very well let investors to champion the causes they care about– without jeopardizing gains. Getting there requires a sea change in how investment products are structured to give shareholders an active say in portfolio companies' decisions.

Let's dive into what's going wrong with the current ESG model, and what the journey to achieving ESG's true aims looks like.

Many investors looking to get exposure to ESG will tap into pooled vehicles, namely mutual funds or ETFs. These funds have exploded in popularity and are projected to grow 84% to account for 22% (!!!) of global AUM by 2026. There's a feel-good element to how ESG funds are marketed; Vanguard positions its ESG products as "a way for you to invest in funds that consider environmental, social, and governance issues".

The problem is that it's total bull****. These funds can't achieve their aims for 3 basic reasons:

Asset managers didn't reinvent the wheel in rolling out ESG funds; they simply created traditional funds, filled them with holdings based on ESG scores assigned by ratings agencies like Refinitiv or MSCI, slapped an "ESG" label on them and called it a day.

The ESG ratings piece is where things get fun:

So a company can pollute all it wants and still earn a high ESG score, as long as polluting doesn't (!) negatively (!) affect (!) its (!) bottom (!) line (!). Presumably companies already take steps to mitigate such risks, so holdings in ESG funds end up looking not-too-dissimilar from those in benchmark portfolios. This helps explain why Vanguard's flagship ESG fund has a 0.9974 correlation to the S&P 500 since inception. The lack of differentiation in ESG portfolios also means that investors are effectively paying three times as much in fees as compared to non-ESG funds.

👩🏽‍⚖️ Regulatory sidebar: The EU is rolling out ESG disclosure requirements that will account for both 1. Bottom-line AND 2. External impacts of their ESG behavior. Meanwhile in the US, the SEC is taking heat for a proposal that only goes as far as requiring the former. The IFRS Foundation, which sets accounting standards used in 167 other jurisdictions globally, announced that its upcoming rules will also only account for financial impacts.

So outside of the EU, there's no path for this to get solved. Ok, end sidebar.

Research points to a clear link between individual companies' adoption of ESG practices and improved financial performance. An analysis of 2,000 ESG papers shows, though, that only 1 in 6 research papers on ESG funds find better performance than non-ESG peers. What gives?

If a company is already doing all of the good ESG things that also make returns good-er, the public market would presumably price these behaviors into the stock without any regard for their ESG-ness. ESG investors now plowing into the stock creates noisiness that would actually harm the company by driving up its cost of capital. As we saw in 2020, retail ESG investors tend to be more skittish than your average bear, and concentrating their money into ESG funds compounds its volatility.

Theoretically, ESG investors could move the needle by voting to adopt ESG practices when corporate elections come around and (fingers crossed!) reap financial benefits when companies enact these policies. But in practice…

Each year, public companies ask their shareholders to vote on major issues that will govern the course of the organization. Lately we've seen an uptick in the number of proposals championing ESG initiatives, as well as growing involvement from activist investors– sometimes leading to dramatic showdowns à la Exxon-board-seat-takeover.

Most retail investors don't actually participate in shareholder voting. Whereas individual shareholders retain the right to vote in corporate elections, mutual fund and ETF investors don't as these funds typically take over voting rights from individual investors.

Institutional funds now account for 69%-70% of ownership in public companies, with three large fund managers– Blackrock, Vanguard, & State Street– dominating the market. At this scale, one of these three fund managers is one of the largest shareholders in 88% of S&P 500 companies. Fund managers also make full use of these voting rights relative to retail investors, voting about 82% of their shares to retail investors' 29%.

In the Good News Corner, major investment managers are now starting to enable pass-through voting for fund investors. Within the past year Blackrock, Vanguard, and State Street have each started to roll out proxy voting pilots (albeit slowly, restricting voting to a small subset of funds and few individual investors, if any).

This is a start! There are still a number of gaps to fill, with a major opportunity for the new generation of investment platforms to:

There needs to be a standardized definition of what "ESG" is. Today’s ESG scores mislead investors to the belief that companies are being graded based on their externalities. They’re also susceptible to greenwashing as companies make deceptive claims and try to boost these scores.

On top of this, the patchwork system of ratings is highly inconsistent, with the CFA Institute finding only a 14%-75% correlation between major ratings agencies’ ESG scores, and evidence showing that companies get assigned higher scores by ratings agencies that have major shareholders in common.

A standard framework would give clarity on what exactly ESG funds proclaim to track (and steer us away from funds that do the opposite).

As anyone who’s received (and likely ignored) an email about proxy voting knows, shareholder voting feels like an afterthought for investment brokers. Traditional investment companies usually outsource proxy voting to third parties like Broadridge or Computershare, who route investors to a site that looks something like this:

This experience isn’t very engaging or informative (and if we’re being honest, it’s ugly).

Investment platforms could do a lot to make proxy voting feel like a core element of the investing process– at the very least, by merging these two into the same UIs. At the same time, they’ll need to catch up to the preferences of an audience that’s rapidly evolving towards younger and majority female ESG investors– demographics that heavily value community, gamification, and social media in their investing activities.

Until recently, the only way investors could participate in shareholder meetings beyond proxy voting was to physically show up to an annual meeting and watch from the sidelines. This was turned on its head when COVID forced companies to hold virtual shareholder meetings.

Broadridge reports that virtual meetings are not only here to stay; they’re opening the floor for shareholders to ask questions and present proposals at historically unprecedented rates. Robinhood’s acquisition of “proxy plumbing” provider Say Technologies was an effort to enable this exact type of engagement. The result was immediate: During Tesla’s Q2 2021 earnings call, Elon Musk answered three questions submitted and voted on by Say users (the unprecedented-ness of this can’t be stressed enough. Companies have basically never allowed individual shareholders to ask questions in these meetings before).

There's so much upside to be unlocked from the ESG. Beyond driving positive societal change, a McKinsey analysis of over 2,000 studies reports that companies with a strong ESG proposition boast higher equity returns in 63% of cases. For investors who want to spark change in firms' behavior (and capture any upside in doing so), purchasing shares in individual stocks and ESG funds is only the start of the battle.

Investment platforms (read: Fintechs) have a major opportunity to pave the way for this change. There's no better time to get started, especially in light of shifting investor demographics, fund managers rolling out pass-through voting en masse, and the tidal wave of enthusiasm from ESG investors that’s been rising in recent years.