Four Counterpoints to ESG Investing Critics

02 March 2022
5 min read

The dramatic growth of sustainable portfolios has raised big questions for investors. Recent prominent media articles have warned of a bubble and criticized sustainable portfolios for being ineffective as agents of change. We think the critics have missed the point.

Sustainable investment funds are mushrooming. Assets under management in Morningstar’s global sustainable fund universe surged to $2.75 trillion at December 31, 2021, nearly three times the pre-pandemic level, according to Morningstar. Net inflows rose by 12% to $142 billion in the fourth quarter of 2021 from the third, while inflows for all funds fell by 6%. Asset managers have rushed to meet surging demand and to counter weaker flows of non-sustainable funds. In the last quarter of 2021 alone, 266 new sustainable funds were launched, bringing the total to a staggering 5,932.    

Dramatic growth has attracted greater scrutiny. Recent articles in the financial media have argued that ESG investing is a bubble and doesn’t work. While investors deserve more transparency, and some funds undoubtedly fail to live up to their billing, many claims about sustainable portfolios are misleading, in our view. Here’s our take on four common critiques.

Claim: All ESG Funds Have Similar Objectives: Not true. Many critical articles and studies incorrectly assume that all ESG funds have the same objectives and follow similar processes. In reality, there’s a broad spectrum of approaches, from passive to active, and from diversified to single theme strategies. Some seek to only own “good actors” with positive social impact while others target “bad actors” to encourage positive change through active engagement. For some, ESG considerations are integrated with the sole intention of reducing risk, while others aim to tap attractive long-term growth opportunities. ESG investing isn’t a one-size-fits all approach and lumping all strategies together is misleading.  

Claim: ESG Investment Is a Bubble: Has the flood of money into ESG funds in recent years created a bubble that is bound to burst? We don’t think the data support that view. While some sustainable (and non-sustainable) stocks trade at excessive valuations, they are a small minority of all ESG stocks. Within our global investment universe of more than 2,000 stocks aligned with the United Nations Sustainable Development Goals, only 7% currently trade at price to forward earnings ratios (for the next fiscal year) in excess of 50x, while 22% have single-digit P/Es. Regardless of how one defines bubble valuations, describing ESG investing broadly as a bubble is an overstatement, in our view. The Wall Street Journal recently wrote: “MSCI’s popular USA ESG Leaders ended 2021 with a forward price-to-earnings ratio about 6% higher than the broad index,”—perhaps a bit pricey, but hardly an ESG bubble by any definition.    

Claim: Recent Underperformance Proves ESG Investing Doesn’t Work: Unlike in the initial downdraft in 2020, most ESG strategies did not provide protection during the January 2022 sell-off. The median global fund in the peer group defined by Morningstar as sustainable declined over 9% and underperformed the broader benchmark by about 4.5%. But we think concerns about the continued efficacy of ESG investing are misplaced. Recent underperformance has been driven more by shifting investment style returns than by ESG issues being out of favor. Many sustainable portfolios are tilted towards growth and quality factors, which underperformed in January. According to Bernstein Research, the sharp rotation toward value stocks in January was in the 99th percentile of all observations since 1978. Focusing narrowly on very short time periods can paint a misleading picture of the efficacy of any investment approach, including sustainable strategies. 

Claim: ESG Investing Can’t Drive Real World Change: Several recent articles conclude that ESG investing fails because allocating capital to “good actors” and away from “bad actors,” as many ESG strategies do, doesn’t change the cost of capital enough to impact real world business decisions. We agree that the data are inconclusive and concede that capital allocation in the secondary equity market is, at best, an indirect form of impact. But not all ESG strategies are impact strategies. And for those that are, changing the cost of capital usually isn’t central to their strategy.

Exerting influence through management engagement is an effective way to make an impact. More broadly, average shareholder support for environmental proposals at US companies jumped to 42% in the first half of 2021, up from 31% in the prior year, according to Glass Lewis. Support for social proposals rose 3 percentage points to 31%. Investors are increasingly focused on social issues and raising their voice to exert influence—and companies are responding. Among Fortune 100 companies, 57% disclosed greenhouse gas emissions reductions goals in their 2021 proxies, up from just 35% in 2020. And 23% disclosed workforce diversity goals, up from 10%.

Regulators Step Up Transparency Efforts

To be sure, the sustainable investing boom is not without risks. Regulators have expressed concern that ESG assets have grown rapidly without clear definitions or reporting standards. “Greenwashing,” or misrepresenting investment processes and objectives to clients, is a real risk. 

In the EU, the Taxonomy Regulation  aims to provide a single, clear definition for what business activities and investing portfolios qualify as “environmentally sustainable.” This is one of the most prominent regulatory initiatives, and it aims to help clients gain a clearer understanding of a portfolio’s sustainability credentials. Similar efforts are underway in the US, UK and Asia. There has been some controversy; recently, questions have been raised about the inclusion of some nuclear and gas projects as sustainable energy sources. Regulation is never perfect. But we welcome efforts to improve transparency and accountability of sustainable funds.

Sustainable investing has become so popular because it addresses real needs that gained prominence during COVID-19. During the pandemic, investors reckoned with converging health, economic, social and climate crises. Attention has rightly shifted to the private sector's massive social impact, and the risks and opportunities businesses face as these crises are addressed. 

Investors have realized that ESG issues are financially material for companies and signaled a clear preference for strategies that explicitly consider them in some way. The market has told us that ceding responsibility for social change to governments alone, as some critics suggest, would be a mistake and a huge wasted opportunity. Portfolios that can truly demonstrate their ability to deliver on ESG objectives and return expectations will help disprove the naysayers and gain investor confidence. 

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to revision over time.

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