Socially Responsible Investing: Can the Ratings Be Trusted?

Globally, $3 trillion in institutional assets (perhaps more) are tracking ESG scores — numbers that purport to distill and quantize companies’ performance against environmental, social, and governance standards.  We reported to you back in November about interesting research showing better stock performance by companies with higher gender diversity among their executives.  Some ESG tracking is driven by the search for better performance — but a good deal is driven by the desire of retail investors who want to feel that their investment portfolios are aligned with their values.

Monitoring firms’ behavior with regard to environmental, social, and governance issues is an intelligent and necessary component of any in-depth analysis of their prospects, since these issues usually matter to a company’s regulators and customers.  Likewise, investors’ efforts to align their portfolios with their personal values is laudable (and it is an effort that we have helped investors with for almost 50 years). 

However, many analysts and regulators have pointed out the limitations of current, standardized ESG scoring — some in harsh terms.  Heather Peirce, a commissioner at the Securities and Exchange Commission [SEC], described ESG scoring systems in scathing terms as “labelling based on incomplete information, public shaming, and shunning wrapped in moral rhetoric.”

The fact that competing ESG scoring systems show only minimal correlation with one another suggests to us that such criticism is cogent.  If they give largely different results, it is likely that they are measuring things inconsistently and inaccurately.  Indeed, when one presses to the bottom of the ratings systems, they seem often to be based on poor-quality and incomplete data.

Anecdotally, we’ve seen similar shortcomings in ESG ratings and in funds based on them.  Often, such funds seem basically to be big-cap growth funds with higher expense ratios: their component companies are a who’s-who of the corporate leaders who can afford to ensure that their ratings are good by checking all the correct boxes. 

Investment implications:  If you want to align your portfolio more closely to environmental, social, and/or governance metrics, for now, you can’t really rely on the standardized metrics that are available.  You need to do granular research on the companies yourself.  Unfortunately, for many metrics in which investors may be interested, there are no good data available.  This may change in the future, but in the meantime, if ESG issues matter to you, you should scrutinize ESG funds that you hold to make sure they are really differentiated from other ETF products which may have very similar contents but be charging a lower fee. 

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