The Truth About ESG

ESG will continue growing as an investment category, but we might not even call it “ESG” in the future. That’s the takeaway from a highly informative panel at the Inside ETFs conference in Hollywood, Florida. 

The panel, “The Truth About ESG,” moderated by Bloomberg Senior ETF Analyst Eric Balchunas, answered all of the key questions about the environmental, social and governance investment movement. 

Balchunas kicked off the panel by describing an ESG-related quarrel that he got caught in the middle of. A few weeks ago, he sent a few tweets that referenced the fact that Tesla had been removed from the S&P 500 ESG Index: 

The tweets were met by a response from Elon Musk, Tesla’s founder and a prolific tweeter with a massive following on the social media platform. 

“My mentions were destroyed for about a whole week with…interesting comments,” Balchunas recalled. But Elon “had a point because to a normal person, Tesla would seem like one of the most ESG companies. When you see soda companies and Exxon [in the ESG index], it’s kind of illogical.” 

“Why is he wrong?” Balchunas asked the panel.  

The first to answer was Reid Steadman, global head of ESG & Innovation, S&P Dow Jones Indices, who largely skirted the issue (one audience member yelled out “you didn’t answer the question!”). But in all fairness, Steadman’s colleague, Margaret Dorn, had laid out exactly why Tesla was kicked out of the index in a blog post a few weeks ago. 

In it, she said Tesla’s lack of a low-carbon strategy; claims of racial discrimination and poor working conditions at one of the company’s factories; and its response to investigations related to deadly crashes involving its vehicles, reduced its ESG score. “While Tesla may be playing its part in taking fuel-powered cars off the road, it has fallen behind its peers when examined through a wider ESG lens,” she said. 

That’s a view that was largely echoed by two others on the panel.  

“Tesla is complicated. In our rankings, it is still the top of its class in the auto industry,” said Hernando Cortina, head of index strategy at ISS ESG.  

But there is “one definite red flag within Tesla, which is there is a verified NLRB [National Labor Relations Board] violation in Fremont, California against unionization. That gets captured into our ranking. So if the index excluded any human rights controversies, Tesla would be out. But if you only look at the ESG rating, that controversy gets outweighed by the positive impact of the company’s products.” 

Cortina explained there is some flexibility with how ESG indices are constructed: “Do you just want to purely focus on a holistic weighting, or do you want to add additional factors that matter to you but perhaps not to other investors?”  

Jonathan Bauman, senior client portfolio manager for American Century Investments, agreed with the idea that there is wiggle room and subjectivity when determining if a company should be considered ESG. 

“It is very subjective and it’s not black and white. We do own Tesla. The environmental benefit of their products helps keep it in the portfolio, but some of the social concerns and governance issues keep it from being a large oversize position relative to the broad market for us,” he said. 

Measuring The Data 

The next topic related to data, including its accuracy and the importance of new types of data on investment decision-making.  

“How do we even know the data that companies provide is accurate?” Balchunas asked. “Are a lot of these companies going to ‘greenwash’ themselves to make themselves look as good as possible?” 

S&P’s Steadman noted his company has direct ties with other companies, and that those firms spend hundreds of hours preparing audited information that they feed into its systems. Some 65,000 documents are uploaded to S&P’s system on an annual basis, he said.

Meanwhile, American Century’s Bauman emphasized that what’s driving stock prices today and what makes up the assets of the S&P 500 today are largely intangibles, and ESG characteristics are just an extension of that.  

In 1975, 17% of S&P 500 assets were intangible; today, “90% are in intangible things—their brands, their reputations, their software—and so you have to pay attention to other things beyond the traditional financial statements to get a more holistic picture of the company,” he explained. 

Outperformance  

For a long time, one point of contention when it comes to ESG is whether investors have to sacrifice performance. In recent years, an ESG focus has actually helped returns, thanks to the outperformance of tech and the underperformance of energy. But this year, those trends have reversed. 

That prompted Balchunas to ask, “How much of ESG is active management in disguise, where you’re making little sector bets or company bets and hoping it does well?” 

The panelists were largely in agreement that while the primary purpose of ESG isn’t outperformance, the category has historically outperformed conventional broad market strategies—though the data sets they cited were relatively small, anywhere from three to 15 years.

“I think there is a narrative where if you invest in ESG, you’re going to underperform. We completely reject that idea,” Steadman said. “We didn’t build the S&P 500 ESG index for outperformance. The goal was to have balance with the S&P 500, industry group by industry group, sector by sector—to stay largely in line. And it is largely in line, even on a risk basis. Factor exposure is also 100% in line, with just a little bit of a size bias on the large side.” 

Demand-Driven Moment  

A key point that the panelists made was that they, as index providers and asset managers, weren’t pushing ESG onto their investors.  

“It’s not about giving up the S&P 500; that index is critical to the market. We find that this is a demand-driven scenario where we are being asked to create [ESG indices],” Steadman noted.  

Likewise, Bauman said that investors, especially younger ones, were demanding ESG funds: “We can tell our investors that by investing in these companies, we have a 67% lower greenhouse gas emissions profile and our companies use 40% less energy.” That’s something that resonates strongly with investors, he said.  

Active vs. Passive 

An area where the panelists didn’t completely see eye-to-eye was whether ESG is best tackled through active or passive management. 

Bauman, whose firm focuses on active management, argued that the flexibility of an active strategy has its benefits.  

He recalled how he recently had a conversation with NextEra Energy in which he was trying to understand its use of coal, which the ESG ratings agencies dinged them for.  

“If you talk to them, all of the coal usage is from acquisitions, and they are retiring those plants quickly and moving them to renewable forms of energy. That’s an active insight you might not get if you just look at ESG scores,” Bauman said.  

ISS ESG’s Cortina took the other side, arguing that indexing’s transparency made more sense for a category where investors already have a lot of questions about what constitutes ESG.  

“If your index says, ‘I’m not going to include tobacco producers,’ then that’s a rule, and the rule will be fixed. You will never have to question why a company is out of an index,” he explained. “There is a lot of clarity for the investor with what you’re getting with ESG. If you want transparency on what an index or ETF is going to do, it’s nice to have those black and white rules.” 

Investor Impact  

As something that makes investors feel good, there’s likely little debate that ESG has an impact. But does it have an impact on what really matters—the real world? Bloomberg’s Balchunas wondered whether the task of making big changes to the world was better suited to governments and consumers.  

S&P’s Steadman was emphatic that change can take place through investors’ collective actions.  

“We see it every day in S&P Global. What happens in the capital markets drives change in the corporate sector,” he said. “As we’re adding and removing companies from these indices, we get calls from those companies asking to understand the data and how they can improve their performance. ESG does drive change in a positive way that can go beyond the capital markets.” 

Bauman agreed with that sentiment and urged investors not to let “perfect” be enemy of “the good.”  

“There is no perfect ESG company. We’re trying to find the cleanest shirt in the dirty laundry,” he said. “But there are companies that are putting zero-emissions goals out there; let’s reward those companies by investing in them.” 

Subjectivity 

In the end, the panel circled back to where it started, which is the idea that ESG is subjective. Bloomberg’s Balchunas noted that the U.S. is a big, diverse place, and that one person’s idea of doing good could be contrary to another’s person’s idea of doing good.  

He pointed to the Constrained Capital ESG Orphans ETF (ORFN), a fund that invests in companies that are excluded from ESG funds, and upcoming ETFs from Strive Asset Management, which will vote against “woke” corporate policies, as evidence of there being some backlash against ESG.  

S&P’s Steadman’s said the best way to recognize people’s diverse views is by giving them choices: “From an index provider standpoint, we try to give many different options. We have a Catholic index and we have a Sharia index. We want to give many different versions of how you may want to look at investments.” 

He also added that it was a difficult task to try and satisfy everyone.  

“There are those who consider the environment the biggest component of ESG and they get upset when you broaden out to ’social’ and ‘governance’ factors,” he explained. “With the S&P 500 ESG index, the goal is to take a temperature of the market and give a common denominator. The goal is to put together a benchmark that addresses the needs of the majority of sustainable investors.” 

Meanwhile, Bauman argued that, ultimately, what is “good” would align with performance.  

“If you think about it purely from an investment lens, we believe that, over time, these companies that have better governance [will have] better outcomes,” he said. “Their employees don’t turn over as often; they have less energy usage. Home Depot talks about it all the time—they switched to LEDs and natural lighting in their stores and their operating costs went down; that’s a good thing for business.” 

“At the end of the day, we think these companies that have ESG policies and procedures ultimately will have more efficient operations, better growth in their market value over time, and the benefits of less impact on the environment,” he continued. “They’ll also take better care of their employees and customers. It’s not a political decision; it’s more of a financial one.” 

The three panelists concluded the session by predicting that in 10 years, assets in ESG funds would make up at least 5% of total ETF assets, up from 1.5% today. But it could be a lot more, especially if other funds incorporate ESG elements into their strategies, without explicitly labeling them as ESG.  

“Twenty years from now, we may not call it ‘ESG investing’; we might just call it ‘investing,’" said Bauman.  

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