ESG Ratings Are Going to Be in Spotlight This Year

After a year in which environmental, social and governance (ESG) funds reached records in terms of population and, more importantly, assets under management, advisors can expect more client inquiries about these products.

For the purposes of this piece, I'm lumping socially responsible and sustainable funds in with ESG, but those are different strategies. Point is investing with virtue is only gaining more traction with clients and more want to invest in ways that are reflective of their values. This is good new for advisors because it brings avenues for increasing client education and engagement.

The other side of all the interest and assets being directed to ESG funds is that scrutiny is increasing, too. Put simply, asset allocators, critics and regulators want to know – and they're looking into the matter – if ESG investing really offers the virtue clients believe they're getting.

Advisors should expect more questions on this front in 2022 because a recent Bloomberg article titled The ESG Mirage made some bold claims about ESG. The article is worth reading, but one of the big takeaways is highlight flaws in ESG ratings because those grades “don't measure a company's impact on the Earth and society. In fact, they gauge the opposite: the potential impact of the world on the company and its shareholders.”

Not As Bad As It Seems

Initially, some clients may be struck, even put off, by the notion that ESG scoring isn't driven by what corporations can do for people and the world, but rather how companies and investors are affected by the world at large. However, advisors should ESG-aware clients gain some perspective on the matter.

“The notion that ESG issues can affect companies financially is not inconsistent with the view that sustainable investors can achieve a broader impact on people and planet. In fact, the two ideas are closely connected,” says Morninstar's Jon Hale.

Advisors can help clients get the heads around this by helping them understand perception isn't always reality. In fact, the reality isn't being obfuscated by index providers and ESG scoring firms, but the fact is clients are conditioned to believe ESG about what companies can do to make the world a better place.

“More clearly stated, ESG ratings of companies, like those of MSCI, Sustainalytics, and many other data providers, attempt to assess the material impact of ESG issues on a company,” adds Hale.

Think about that in terms of some of the ESG issues affecting companies today. For example, climate activists are pressuring banks to reduce or eliminate lending to fossil fuels producers. Another example, is Nasdaq requiring companies that list on that exchange to have at least one woman and one minority on its board of directors.

There's Good News

As Morningstar's Hale points out, ESG ratings serving as a barometer for “risks and opportunities for companies” isn't a new concept. It's actually a foundational piece was documented over 15 years ago in a  United Nations report called Investing for Long-Term Value.

While there's still likely to be ample consternation and criticism about the social and governance elements of ESG, there is some confirmation that climate-sensitive strategies bear fruit for clients.

“Green assets delivered high returns in recent years. This performance reflects unexpectedly strong increases in environmental concerns, not high expected returns,” notes Alpha Architect. “German green bonds outperformed their higher-yielding non-green twins as the 'greenium' widened, and U.S. green stocks outperformed brown as climate concerns strengthened.”

Bottom line: There's a lot of work to be done when it comes to ESG ratings and advisors should impart upon clients ESG scoring isn't perfect today, but it is evolving and clients can expect more impact metrics to be applied to fund construction in the years ahead.

Related: Bridging the Gap Between the ESG Investing and the Financial Industry