European regulators have been cracking down on so-called "greenwashing" among fund managers, resulting in "mass frustration" among managers. In the last few weeks, some of the largest asset managers in the world have removed the much-sought-after ESG (environmental, social and governance) classifications from their funds.
Photo of former AQR Capital partner Roni Israelov, now chief investment officer at wealth manager ... [+]
ESG regulations cause chaos in Europe
However, that's not the only source of decreases in the number of available ESG funds. In a recent survey, Jefferies uncovered an 84% decrease in fund reclassifications to include some element of ESG. Europe's Sustainable Finance Disclosure Regulation was aimed at increasing transparency in sustainable investments and other ESG-related vehicles, but it appears to have reduced the number of available options available to investors.
Regulators' recently increased restrictions have caused chaos among European investment managers. The issue stems from the multitude of different ESG rating and classification systems. It's clear that no one can agree on which companies should be considered ESG-friendly — and which should not.
Many have raised an outcry over certain stocks, like oil major Exxon Mobil, receiving a higher ESG rating than others, like electric vehicle maker Tesla. However, former AQR partner Roni Israelov, now chief investment officer at wealth manager NDVR (pronounced "endeavor"), believes greenwashing is less of a concern than most investors realize — and that much of it is actually a misunderstanding.
Why ESG might not be a bad-actor problem
In an interview with ValueWalk, Israelov says he believes some of the uproar over ESG ratings is due to deficiencies in the proprietary scoring systems used rather than a matter of widespread bad actors in ESG. He does agree that there probably are some bad actors, but he thinks they are in the minority of those being accused of greenwashing.
"Part of what people criticize greenwashing for… the challenge I have with it is there are too many steps between an investor with the specific values they care about and the portfolio delivered to them," Roni explains. "So if we walk through it, it starts with a ratings agency's proprietary methods for scoring individual companies across a large set of measures."
Of course, there is significant disagreement across the many ESG ratings agencies around the globe about what makes a good or bad ESG company. The former AQR partner believes much of that disagreement is because those firms are trying to take qualitative data and quantify it.
"A lot of well-meaning, thoughtful people do this in different ways and reach different conclusions," he explained. "Academic research has shown that governance and social correlations across ratings providers are almost zero. Essentially, they don't agree with each other on what makes a company good or bad on a number of measures."
Those widespread differences by ratings agencies stem from the extreme difficulty of creating those ratings and the differences in opinions on what makes a company strong or weak in ESG. That's only the first step in the portfolio construction process. Asset managers then license those proprietary ratings and use them to make investment decisions.
"There are a lot of decisions made in portfolio construction that can alter the portfolio you get, even if two asset managers license the same ratings," NDVR’s CIO opines. "… So they start with potentially different ratings that are supposed to capture ESG and then go to the next step. Different portfolio construction methods are applied to those ratings. That leads to hundreds or thousands of different portfolios for people to invest in."
Differences of opinion lead to greenwashing accusations
Roni believes the widespread controversy over Tesla's, Exxon's and Amazon's
He added that one investment manager might believe he's building an ESG-compliant portfolio, while another is looking at the data from an entirely different lens that leads him to very different conclusions. As a result, one of these investment managers is accused of greenwashing — even though they merely interpreted the ESG data differently.
"I'm hesitant to apply that label because I understand how differences in process and in how ratings are applied or constructed can lead to an alternative view of a portfolio," Israelov states.
Benchmark hugging
Another concern with ESG funds is that many of them hug their benchmarks despite supposedly being actively managed. Israelov believes certain criteria dictate the level of difference a fund must have from its benchmark in order to say that it's actively managed. In the world of ESG, it can be challenging to construct a portfolio that's dramatically different from its ESG benchmark because the investable universe is much smaller.
"Investors, even if it's an ESG-compliant portfolio, don't want to deviate from their benchmark too much," the fund manager. "One of the issues is industry exposure. When building portfolios, managers may exclude or overweight certain stocks but try to manage the portfolio so that industry composition is not materially different from their benchmark."
For example, investors with an ESG view that excludes energy due to environmental concerns may also have constraint limits on industry exposures in their portfolios. In such a scenario, Roni advises overweighting the best energy companies and excluding the worst energy names without reducing the overall allocation to energy as a whole.
"Many argue that an ESG-compliant portfolio rewards green energy while punishing those that are less green," he said. "Others look at the same portfolio, see it has the same energy exposure, and see greenwashing. It's a difference of opinion in portfolio construction, so… I recognize that well-intentioned people come to very different, reasonable conclusions on how to implement ESG portfolios."
Is Amazon an ESG-friendly stock?
There was a massive uproar when Tesla was removed from the S&P 500 ESG Index due to its lack of a low-carbon strategy and allegations of racial discrimination and poor working conditions. However, Tesla is not the only stock many investors are upset about in terms of its ESG rating.
Many investors who shun ESG investing for reasons such as the removal of Tesla from the ESG index have also pointed out that Exxon Mobil has a higher rating than the EV maker. Additionally, there's controversy about whether e-commerce giant Amazon should be classified as ESG-friendly.
The company has a sizable carbon footprint due to its strategy of delivering goods as quickly as possible and may be considered a troublemaker on deforestation. However, Israelov believes the controversy over Amazon's ESG status again stems from differences of opinion.
"Amazon was flagged for deforestation [in NDVR's system], but for ESG scores, the ratings agencies decide how much that matters," he explained. "If you look at one of the controversies that arose in 2022, the S&P 500 ESG committee chose to exclude Tesla but include Exxon Mobil, not based on environmental concerns but on other criteria. Many criteria go into ESG, and it's not always obvious what is weighted heavily and what is less important."
The ESG evolution
Given ESG's popularity, it clearly isn't going away any time soon. Roni expects continued, growing interest and controversy in the space amid growing challenges. As a result, he thinks it will be interesting to track how this investment space continues to evolve over time to best meet the needs of the end investors who care about investing along their values.
Although he thinks much of the greenwashing accusations stem from misunderstandings, Israelov also believes this issue is one reason investment managers outsource their ESG needs to ratings agencies. He doesn't believe every investment manager or registered investment advisor has the capacity to investigate every individual stock in depth like ratings agencies do. He notes that some managers rely on ratings agencies for their ESG-related due diligence.
