Finance & Accounting Dec 20, 2022
5 Takeaways on the State of ESG Investing
ESG investing is hot. But what does it actually deliver for society and for shareholders?
For the past several years or so, major funds, managers, and institutional investors have been stocking their portfolios with investments in firms that claim to be engaged in positive environmental, social, and governance (ESG) activities.
On the websites of actively managed funds, investors show giant banners touting a commitment to invest in firms working to make the world a better, safer place, says Aaron Yoon, assistant professor of accounting and information management at Kellogg. But what do these funds actually deliver—for society, and for investors?
In a recent The Insightful Leader Live webinar, Yoon described the state of ESG investing today and what might happen in the future. Here are five takeaways from his talk.
ESG Investing Is Hot, Hot, Hot
“ESG investing has just exploded,” Yoon says. Assets under management that signed the United Nations Principles for Responsible Investment initiative have grown from just a few hundred billion dollars in 2006 to $120 trillion in 2021. That means “roughly three times the entire U.S. market cap has committed to incorporate ESG information into their decision-making process.”
Perhaps it’s unsurprising, then, that company executives really want their stocks to be in those funds. ESG investing has become so popular that now “almost all firms are claiming that they are engaging in ESG issues and valuing ESG as a very important investment activity,” Yoon says. Roughly 90 percent of S&P 500 firms publish reports on their ESG, sustainability, or corporate social responsibility activities.
In a sign that the pace of ESG reporting is not going to abate, a group of nearly 200 of the largest U.S. corporate CEOs, known as the Business Roundtable, signed a statement in June 2019 saying the purpose of a corporation is to promote “an economy that serves all Americans.”
The idea, endorsed by JPMorgan Chase Chairman and CEO Jamie Dimon and others, is that companies should end their focus on creating value solely for shareholders and focus instead on creating long-term value for a variety of key stakeholders, including employees, customers, suppliers, and community members—in addition to shareholders.
It Can Be Hard to Make Sense of a Company’s ESG Efforts
Yoon is somewhat skeptical of proclamations like that of the Business Roundtable, which may be more about telling investors what they want to hear than a real change in business-as-usual.
So instead of taking CEOs at face value, Yoon argues, it can be more helpful to think about ESG as one of many investments a firm can make. ESG activities require resources like employee time and capital, and they should deliver some kind of return that increases the value of the firm.
Yet, even this approach is still problematic. In general, investors typically turn to standardized financial statements to identify good investments. When it comes to company ESG reports, however, this is nearly impossible to do. “All of these reports are unaudited and contain information that is voluntarily disclosed in order to promote companies,” Yoon says.
This means that, when firm leaders tout their ESG investments, it is not obvious what investors should do with that information, nor is it easy to tell whether these investments are “worth it” in any traditional sense.
There’s Not Even a Consensus on Measuring ESG Activities
Into this confidence gap a new industry has emerged to rate firms on their ESG activities. Organizations including MSCI, FTSE4Good, and Sustainalytics all issue ESG ratings.
Still, each one grades the same companies differently, and there isn’t a consensus on which companies’ ratings are superior, or even how that should be determined. “There’s no agreement on what these ratings should measure,” Yoon says. “Is it impact on the world? Or the impact of the world on the company’s bottom line? Is it value, or risk, or avoiding negative events?”
In his own research, Yoon found that mutual funds marketed as ESG (after they commit to the UN’s Principles for Responsible Investment) attract a huge spike in quarterly capital flow from asset allocators like pension funds. However, “we observe effectively no change in fund-level ESG performance. Also, there is no improvement in fund return—there is actually a slight decrease,” Yoon says.
Not only that, Yoon found that even six quarters after fund managers sign the UN PRI commitment, there was no evidence of meaningful follow-through in ESG performance. That could signal the funds, and the companies whose stocks they own, are merely engaging in greenwashing.
There Are Some Investments That Create Positive Returns
Still, it is not impossible to value the impact of ESG investments, Yoon says. The key is to think like a hedge fund and look for some type of signal that will sort the value-creating ESG efforts from the irrelevant ones.
One way to do this is to separate ESG efforts into activities that are related, or material, to a firm’s business practices, and those that are unrelated, or immaterial, to the core business. For an oil and gas business, investing in reducing carbon emissions is material. Similarly, for a food and beverages company, sourcing more sustainable ingredients would also be material. In contrast, a big bank moving to a certified environmentally friendly headquarters is immaterial.
Yoon’s research has found that a hypothetical portfolio that bought firms with high spending on material ESG activities performed significantly better over a 20-year period than a portfolio of firms with low spending on material ESG activities. High spending on immaterial ESG activities was not associated with any such boost.
The Future of ESG Investing Is Understanding Value Creation
Over the last decade, the market has been on a tear, allowing any ESG commitment to win over investors. But Yoon does not expect this to continue. “During market turmoil and downturns, highlighting ESG issues that create value for the firm, and the shareholders, is very important,” Yoon says.
Eventually, disclosure for ESG-related financial information will be regulated, as other kinds of financial information is. But for now, investors will have to work with what companies choose to report.
“If all managers are now forced to engage in ESG issues, we can ask, who does it better, why are they doing it, and how do they justify the use of shareholder resources?”
For more details, watch the full webinar above.
Melody Bomgardner is a freelance writer in Bend, Oregon.
How Are Black–White Biracial People Perceived in Terms of Race?Understanding the answer—and why black and white Americans may percieve biracial people differently—is increasingly important in a multiracial society.
Don’t Wait to Be Asked: LeadA roadmap for increasing your influence at work.
How (Not) to Change Someone’s MindPsychologists have found two persuasion tactics that work. But put them together and the magic is lost.
Which Form of Government Is Best?Democracies may not outlast dictatorships, but they adapt better.
How Autocracies UnravelOver time, leaders grow more repressive and cling to yes-men—a cycle that’s playing out today in Putin’s Russia.
Knowing Your Boss’s Salary Can Make You Work Harder—or Slack OffYour level of motivation depends on whether you have a fair shot at getting promoted yourself.
Will AI Eventually Replace Doctors?Maybe not entirely. But the doctor–patient relationship is likely to change dramatically.
Sitting Near a High-Performer Can Make You Better at Your Job“Spillover” from certain coworkers can boost our productivity—or jeopardize our employment.
It’s Performance Review Time. Which Ranking System Is Best for Your Team?A look at the benefits and downsides of two different approaches.
Why Do Some People Succeed after Failing, While Others Continue to Flounder?A new study dispels some of the mystery behind success after failure.
Four Strategies for Cultivating Strong Leaders InternallyA retired brigadier general explains how companies can prioritize talent development.
Entrepreneurship Through Acquisition Is Still EntrepreneurshipETA is one of the fastest-growing paths to entrepreneurship. Here's how to think about it.
Take 5: Not So Fast!A little patience can lead to better ideas, stronger organizations, and more-ethical conduct at work.
Too Much Cross Talk. Too Little Creativity. How to Fix the Worst Parts of a Virtual Meeting.Six tools from an unlikely place—improv comedy—to use on your next Zoom call.
Take 5: How to Be Prepared for Important Career MomentsExpert advice on getting ready to network, negotiate, or make your case to the CEO.
Why Do Long Wars Happen?War is a highly inefficient way of dividing contested resources—yet conflicts endure when there are powerful incentives to feign strength.
2 Factors Will Determine How Much AI Transforms Our EconomyThey’ll also dictate how workers stand to fare.
What Went Wrong at AIG?Unpacking the insurance giant's collapse during the 2008 financial crisis.
5 Tips for Growing as a Leader without Burning Yourself OutA leadership coach and former CEO on how to take a holistic approach to your career.