Tech Me Out to Dinner; Let’s Talk ESG Funds
With tech stocks being sacrificed at the altar of rising interest rates and with increased scrutiny of ratings and definitions, the Environmental, Social, and Governance (“ESG”) funds are having their feet held to the fire.
As of yearend 2021, designated ESG funds represented 10% of total worldwide fund assets. This magnitude, and the record breaking recent inflows to ESG funds — $650b in 2021 — represent a broader cultural shift as individuals and investors push for the business world to consider the outcomes it produces beyond shareholder value. ESG funds purport to offer a solution, presenting themselves as a way for investors to “do good while doing well,” to generate positive impact while multiplying their dollars. But as both Voltaire and Spiderman would caution, “with great power comes great responsibility,” and the intensity of scrutiny and inquiries surrounding these assets is percolating. Do they actually outperform the broader market? Are they truly more sustainable or generating more positive impact than non-ESG funds? And how is this being determined?
One key criticism driving recent scrutiny: ESG funds are simply tech funds. According to sources such as Refinitiv and MSCI, top holdings for the large ESG funds often feature tech giants such as Microsoft, Apple, Alphabet, and Meta (i.e. Facebook). At least part of what has driven strong returns for ESG funds over the last few years is this heavy weighting towards the tech sector (a weighting that has backfired recently with these stocks taking a hit). If ESG funds are simply tracking the largest weights of the S&P 500, some ask, what is the value-add? It doesn’t help that the energy sector, composed mainly of fossil fuel intensive stocks, was the best performing sector in 2021. This could have significant implications for ESG funds which have heavy tech exposure and are typically underweight in sectors such as industrials and resources which are often less environmentally friendly.
Beyond a high beta, this revelation also begs the question: why tech? Is investing in Microsoft and Alphabet really “doing good while doing well”? First, we have to consider “impact” and ESG terms that are often conflated but are not the same. Defined simply, an “impact” company is one in which the positive impact created is directly tied to the business model, wherein for each unit sold there is a measurable positive outcome. Take Beyond Meat: for each Beyond burger purchased instead of a traditional burger, 90% less greenhouse gas emissions are produced, 46% less energy is used, and 99% less water is consumed. ESG investing tends to look at all companies and determines how they perform relative to factors such as human rights, pollution, and corporate behavior. Microsoft and other tech firms may not be “impact” companies but they perform better than others based on ESG factors, primarily due to the incidentally lower emitting nature of their business models as well as the presence of certain HR policies, which can increase a company’s score even if they don’t actually do anything new.
This brings us to ESG’s primary challenge: data. ESG funds tend to select tech companies due to their lower carbon footprint, and carbon footprints are currently the most easily measured metric. Other issues like labor rights or data privacy might ding these companies’ ESG scores but this data is less available and much murkier. A lack of data leads to dubious ESG scores, which has implications for both actively managed funds who leverage them for diligence and for passive funds which track indices based on these ratings.
As companies improve their ESG reporting — both of their own volition and mandated by the SEC, the EU, and more — these ratings will become more precise and reliable. This will likely result in greater sector diversification of ESG funds as they will have the data to make more nuanced selections based on ESG scores. We’re also likely to see more thematic and “impact” oriented public equity funds as the portfolios of impact venture investors mature. We here at FWP acknowledge the long road ahead of making ESG investing deliver on its promises to “do good while doing well” and are excited to be a part of that project.
Madelyn O’Farrell, Analyst, Private Investments
Retirement funds may soon be permitted to consider ESG as part of their investments as the Department of Labor moves to reverse a Trump-era rule in which it was prohibited.
Want a solution for better ESG data and reporting? Check out YvesBlue, a Flat World-incubated ESG tech solution.
Interested in what comes next for ESG? Check out these 7 predictions for 2022.
This newsletter is intended solely for informational purposes, and should not be construed as investment/trading advice and are not meant to be a solicitation or recommendation to buy, sell, or hold any securities mentioned. Any reproduction or distribution of this document, in whole or in part, or the disclosure of its contents, without the prior written consent of Flat World Partners is prohibited
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