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Do you know what’s really in your ESG fund?

“Virtuous” investing is all the rage, but thousands of individual investors are being misled into supporting companies that probably don’t align with their values.

(CN) — There’s a massive disconnect between what many individual investors believe about ESG funds and what the funds actually do, which means that thousands of people who think they’re changing the world by aligning their portfolios with their values may actually be changing the world in a way they don’t like.

Investors pumped half a trillion dollars into ESG funds in 2021 alone, according to J.P. Morgan, and nearly half of U.S. retail investors, including three-quarters of people under age 40, say they prefer investing in companies that benefit the environment and society. But ESG funds — those that invest based on environmental, social and governance criteria — have no standard metrics and there are often wild divergences in how companies are rated. In other words, many of the largest ESG funds shovel money into companies that are anything but “virtuous” in the minds of their customers.

Investors concerned about climate change might be surprised that the S&P 500 ESG index includes the country’s leading producer of fossil fuels but not the leading producer of electric vehicles, for example.

The top holdings of one of the largest ESG funds, the iShares ESG Aware MSCI USA ETF, include fossil-fuel producer Exxon along with companies that have been described in the press as “the nation’s fiercest anti-union employer” (Amazon), make 90% of their products in a country with a terrible human rights record (Apple), have been harshly criticized as anti-consumer by Senators Elizabeth Warren and Bernie Sanders (JPMorgan Chase), and have been attacked by Warren as a dangerous monopoly that should be broken up (Google). The fund also invests heavily in Coke, Pepsi, Kellogg and General Mills, which produce sugary drinks and cereals that can lead to obesity and diabetes.

Another very popular ESG fund, the iShares MSCI USA ESG Select ETF, has a $20 million stake in Halliburton, which is responsible for most of the world's fracking operations.

FTX, the cryptocurrency trading platform that collapsed in November amid allegations of embezzlement by its top officials, was given a higher “leadership and governance” score than Exxon by ESG rating agency Truvalue Labs.

A shocking study by professors at Columbia University and the London School of Economics found that ESG funds overall invest in companies with worse track records of complying with labor and environmental laws than non-ESG funds, and they also invest in companies that produce a higher level of carbon emissions per unit of revenue.

Many ESG funds are simply profiting from consumer misperceptions, but some may be actively encouraging them. Last year BNY Mellon paid a $1.5 million penalty for falsely claiming that all the investments in its funds had undergone an ESG quality review, and Goldman Sachs paid $4 million to settle similar claims. German authorities recently raided the offices of Deutsche Bank looking for evidence of false advertising of ESG funds.

“Retail investors don’t understand ESG investing,” said Gerri Walsh, president of the FINRA Investor Education Foundation. The foundation conducted a survey that found that 77% of retail investors think ESG funds align with their values — but only 21% could even correctly identify what ESG stands for.

Florian Berg, an M.I.T. business school researcher who studies the industry, warned that there can be four standard deviations between how one ESG rating agency treats a company and how another one does — even as these funds "implicitly sell a change in the real world."

“So one agency thinks it’s great and another thinks it’s really bad," Berg explained.

Tobacco companies are a good example. Because they make a product that kills people, some rating agencies give them very low scores, but others focus more on their environmental impact and employment practices and give them a much more positive score.


Tesla is another example: Some raters give the company top marks because its cars are environmentally friendly but others downgrade it because of its production practices and other issues.

One leading rating agency puts Wells Fargo in the 77th percentile for governance while another puts it in the 4th percentile, noted Matthew Souther, a professor at the University of South Carolina business school.

Tesla CEO Elon Musk attends the groundbreaking ceremony of the Tesla Shanghai factory in China on Jan. 7, 2019. (Ding Ting/Xinhua via AP, File)

In a major scandal a few years ago, Wells Fargo employees opened millions of fraudulent accounts for unwitting customers, leading to a $185 million fine against the company. This tanked its ESG rating at the agency that considers “business ethics” important, but not at the other agency that is more focused on board composition, Souther explained.

A recent study found that one leading rating agency had Facebook in the top 10% on environmental concerns while another considered it below average, and one put Walmart’s “social” score in the 61st percentile while another put in the 10th.

Berg’s research found wildly different ratings for companies in a broad range of industries including Intel, Honda, Johnson & Johnson, AT&T and Bank of America.

There are more than 70 rating agencies and each has a proprietary method for evaluating ESG issues. Some look at a few key factors and others consider a multitude of them. Some update their ratings daily and some do so once a year. Some use publicly available corporate data, some use questionnaires, some consider media reports, and some allow companies to respond in an effort to change a rating, while others don’t.

On top of this, many of the larger ESG mutual funds completely ignore the agencies’ ratings and instead simply factor their raw data into investment decisions, Berg noted. A large number of mutual fund managers view agencies’ ESG ratings as essentially worthless, according to a survey by think tank SustainAbility, with “almost all” fund managers complaining that the ratings are produced by inexperienced analysts and are riddled with inaccuracies.

The problem is “garbage in, garbage out,” said Kenneth Pucker, a director at Berkshire Partners who teaches at Tufts University. “The reporting is not complete, results are mostly unaudited, and they are not comparable.”

Another issue is that ESG is an extremely vague concept with no broadly accepted meaning.

“Even just focusing on the environmental component — how do we define that?” Souther asked. “Carbon emissions? Water usage? Production of sustainable products? Renewable energy usage? Green patent filings? Protection of biodiversity? You could come up with a nearly infinite number of ways to evaluate a firm's environmental performance.

“And then you have to come up with a way to measure all those things and combine them into a single environmental score. There are also an infinite number of ways to do this. Should some of those things be weighted more heavily than others? How do we determine what inputs are most important and should be weighed heaviest?”

Weighting is complicated because each industry is different, Berg said. “Carbon emissions are a lot more important for an aluminum company than they are for WeWork,” he noted.

Government regulation hasn’t kept up with the burgeoning field. While the SEC has brought a handful of enforcement actions, it hasn’t issued any ESG-specific enforcement guidance and is relying instead on traditional anti-fraud and disclosure rules, said Daniel Hawke, a securities lawyer at Arnold & Porter in Washington.

That’s a problem, Hawke said, because “greenwashing” — suggesting that a company is more environmentally friendly than it is — can be a subjective judgment. “It’s unclear what is fraud,” he noted. “No one has articulated the standards of disclosure. When is something required to be disclosed? What is important to investors? All of that is evolving, and the absence of rules makes things precarious.”

So what can individual investors do?

A first step is to look at the top holdings of a mutual fund to see if they’re companies you’re comfortable with. You should also note if a fund is socially responsible — which means that it avoids investing in companies focused on gambling, tobacco, weapons, etc. — or takes a best-in-class approach —which means it invests in all industries but tries to pick the most responsible players in each.

Some investors want to avoid fossil fuel companies altogether, but Berg said the problem with “divesting blindly” is that a lot of the leading green research and development is being done by those companies.

There’s also a difference between funds that simply buy ESG-favorable companies and those that actively use their proxies and influence to have an impact on corporate policies, Berg noted.

“If I just buy stock in a good company, the price goes up, and someone else takes a profit and the price goes back down, and there’s no impact,” he said. “The company doesn’t know I’m a green investor, and there’s no real change.”

Last year the SEC did propose new rules that would require ESG funds to provide more information to help investors compare products, including requiring “impact” funds that focus on proxy voting to offer more details on their strategies.

Despite all the issues, ESG investing isn’t useless, Berg insisted. “There’s a lot of noise," he said, "but there’s also a lot of signal in the noise.” For individual investors, however, filtering out the noise might be a lot more work than they thought.

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