Is there a sustainable future in ESG investing?

The original version of this article first appeared in The Business Times.

Step outdoors in Singapore and a blast of hot, humid air greets us — and a little more warmly with the passing years.

Heatwaves have meanwhile enveloped Europe and the US this year, with Southern Europe hit by wildfires as temperatures pushed above 40 degrees Celsius. The US has reported deaths from the punishing weather. Global crop yields are being hurt, while biodiversity is under siege. The cause? Scientists have determined it to be climate change.

The devastation from climate change is the threat to the world we live in today. It sets the backdrop for reassessing sustainable investing, as it comes under scrutiny in recent times.

The idea has been that investing based on environmental, social, and governance (ESG) factors allows you to do good without sacrificing returns. This was the case just two years ago. In 2020 and 2021, all large-cap US stock funds returned 23.4% a year per invested dollar, in line with the S&P 500 index as data from Morningstar showed. ESG-focused large-cap funds beat that with a 25.2% annual return.

That has also explained the surge of inflows into ESG investments. As of end-December last year, US$28 trillion in global assets were reported to be managed under ESG principles.

In 2022, that outperformance fizzled out. In the first quarter, all large-cap US stock funds fell an average of 5.6% on an asset-weighted basis, said Morningstar. The ESG funds in the group did worse, falling almost 7%.

That’s because the only major sector doing well in a market slump has been oil. The Russia-Ukraine war since late February has prompted a surge in oil prices. Brent crude is up by more than 30% since the start of the year.

But ESG funds naturally shun oil-and-gas counters. EPFR Global data showed that global ESG funds had just a 1.5% weightage in energy as of February. For all stock funds, that weighting is at 4%.

The other key factor is that ESG funds have held more growth stocks, which have today been slammed by rising interest rates. Higher rates effectively raised the expectations of performance from listed tech companies to justify their lofty valuations.

This year’s underperformance from ESG-related investments has given investors pause. In May, a record US$2 billion flowed out of US ESG equity funds, according to Bloomberg Intelligence data.

The criticism then is that the boom in ESG funds merely rode the bull market that ended in 2022 — and the “do well and do good” narrative is coming undone.

Patient capital

But this scrutiny is healthy for the markets. The reality is that ESG-related policies do not materialise in a matter of days. From tougher labour laws on sweatshop production, to exploring the future of green energy rolled out at a global scale — these are transitions that take years, even decades. Expectations behind ESG investing should be recalibrated then. Investors should be prepared to reap better returns, but over the long term.

To add, the ongoing Russia-Ukraine war should prompt a bigger conversation around global energy dependencies, and the future of fossil fuels. If policies are tightened to incentivise green energy research and development, while further penalising excessive burning of fossil fuels, then investors that are heavily exposed to oil-related sectors will eventually see their returns diluted. Stranded assets due to policy shifts will have to be heavily marked down.

The reckoning in the ESG investing space should also spur investors to better understand what their ESG portfolios are exposed to, and to more clearly understand the contradictions amid such broad and sweeping transitions.

A company may excel on the environmental (E) front, but score poorly on the governance (G) aspect: investors will have to weigh the trade-offs against their own investing priorities when it comes to ESG factors.

There is a broader wrestle of social responsibility if ESG-led policies mean coal-fired power plants can no longer be built to supply electricity to households of developing markets that need it.

As another example, tidal-powered turbines may create a downstream effect on marine life and seal population. There is no evidence that seals are directly affected by this technology, although a study of the harbour seals in a part of Scotland showed a 85% decline in the seal population in the past 20 years. Many factors are likely at play, but it highlights the need for more research done on the impact of new technologies and industries on the environment and other ESG-related factors.

All of these will take time to reconcile. By its nature, ESG investing is not meant for impatient capital — and rightly so.

Read more: An A to Z of climate change terms for investors. To understand the subtle differences between ESG investing, socially responsible investing, and impact investing, click here.

Inconsistent standards

The growing criticism and backlash for ESG investing are understandable; investors care about the bottom line. They want to “do well and do good” and now, the “do well” part of the equation is not adding up anymore.

Schroders’ annual Institutional Investor Study 2022 showed that just over half of institutional investors said concerns over ESG performance are hindrances for investing sustainably. Many of them prioritised evidence of improved financial performance when investing sustainably, and wanted more clarity around the different sustainable investment options.

The problem of inconsistent standards is well-documented. On one level, the companies that funds are invested in could be misreporting their efforts and progress on their ESG integration efforts. The fund managers themselves could also be embellishing their ESG integration efforts. The news about a large fund manager whose office was raided by the German police on suspicion of investment fraud related to ESG claims is still on people’s minds.

Regulators are taking steps to address this. Starting next year, fund managers in Singapore must disclose the investment strategies, metrics and criteria of ESG-related retail funds, the Monetary Authority of Singapore announced in July.

The reality is that it is not as tough to measure the relative investment performance of ESG focused strategies by comparing against broad-based indices. The “do good” objective is much harder to unpack.

But just because the “do good” aspect is difficult to measure, compare, and assess, doesn’t automatically make it irrelevant. What we need is to commit to standardisation, and to be transparent to customers about the extent of ESG impact from their ESG investments.

That’s especially as the biggest opportunity is likely from companies transitioning to a low-carbon or zero-carbon model. Those that have relatively weaker ESG scores now but with the potential to improve with the help of asset managers and owners who are willing to engage on best practices would make the most impact.

As the industry converges around the idea of a consistent framework and a set of standards for reporting and evaluation, there is certainly hope that assessment of ESG performance will no longer be a one-dimensional relative return figure but a multi-faceted approach that takes into account the dual objective of ESG investing.

In July, Endowus became a signatory of the United Nations' Principles for Responsible Investment (UN PRI), signalling our commitment to include ESG factors in investment decision-making and ownership.

For all the contradictions behind sustainable investing, the ongoing work behind it speaks to a conviction that this trend will endure. Today, the investing community is coming to terms with the fact that ESG investing is about defining trade-offs. That simply reflects the reality of the world we live in — the same one we’d like to preserve, imperfect as it may be.