The Dark Side of ESG: What Has Asset Managers Concerned

Many investors want to align their portfolios with their values. For example, they may feel strongly about the negative effects of climate change and seek out investments that promote renewable energy. Asset managers often promote ESG funds as an easy way to balance profit and purpose to support the greater good.

The problem is that most ESG funds are ‘exclusionary’, which means they avoid investment in certain ‘bad’ companies. Excluding these companies may raise their long-term cost of capital, but it’s unclear if the impact is significant enough to make a difference.

Inclusionary ESG funds actively invest in ESG-focused projects, but few have demonstrated ‘additionality’, or achieving a real-world impact that wouldn’t have occurred otherwise. In other words, the ESG-related projects that they support could have obtained similar financing from other non-ESG sources, such as a bank loan or equity investment.

Finally, ESG investments may help feed the narrative that the ‘free market’ is self-correcting and government regulations are unnecessary. On an individual level, investors may also feel that their ESG portfolio sufficiently addresses their environmental or social concerns and avoid other more impactful activities, such as changing their behaviors.

Asset managers love ESG investments partly because they come attached with higher fees. According to Morningstar, the asset-weighted average expense ratio for ESG funds was 0.61% compared to 0.41% for their traditional peers. These significant financial incentives may encourage some asset managers to engage in misleading marketing campaigns.

For instance, several asset managers have come under pressure for ‘greenwashing’ their portfolios, or claiming an ESG focus without evidence. While the SEC and other watchdogs are setting up regulatory and supervisory frameworks, the U.S. ESG market remains largely unregulated, leaving investors to conduct their own due diligence.

Be sure to check out this article to learn more about greenwashing.

Many asset managers also promote ESG funds as ways to outperform the market while making a positive impact—a win-win for everyone. While ESG funds beat their traditional peers in the past, there’s no guarantee that these funds will continue to outperform. In fact, the growing interest in ESG could diminish its competitive edge over time.

Of course, there are some legitimate and effective ESG options for investors. For example, the Transform 500 ETF (VOTE) successfully voted in its slate of directors at Exxon Mobil (XOM) to force positive ESG-related change at the oil giant. Also, many actively managed ESG-focused ETFs support renewable energy and other initiatives.

Investors that want to align their portfolios with their values should be wary of ESG-related marketing claims and ensure that funds are effectively influencing ESG-related outcomes. That often means looking at actively-managed funds that focus on inclusionary opportunities, as well as proxy-focused funds affecting long-term change on the board.

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