ESG funds: saviors of the planet or asset management scam?

Regulators are cracking down on greenwashing in ESG funds: pretending you are an ESG  fund that wants to save the planet without actually investing in green stocks. The European Union has recently adopted a corporate sustainability reporting directive that specifies guidelines to be followed if you market yourself as an ESG fund.  The SEC is proposing similar rules to require ESG funds to disclose information about their strategies. However, even without greenwashing, investors are misled by ESG fund promoters. A typical advertisement for ESG funds will read like this:

“Investors in the fund will (1) reduce global warming and (2) do this without giving up returns”. 

even without greenwashing, investors are misled by ESG fund promoters

The first part of this statement is almost sure a lie. The typical ESG fund gives no money to the companies in their portfolio. The funds exploit the apparent ignorance of many investors who confuse financial investment in stocks with capital expenditures. Many believe that if they invest in e.g. the Wind Energy Fund they actually give money to the firms in the fund to produce wind energy.  Nothing is further from the truth : the money invested in the fund is used to buy shares from other investors who sell their wind energy shares and, who knows, buy a gasoline powered SUV with the proceeds.  The underlying companies are not affected. Some funds try to counter this by saying they “engage” with the company and send emails to the CEO. But what’s the point of engaging if the company is already a high ESG rated firm ?  Engagement would make sense if the fund would buy low ESG rated stocks such as oil and gas companies and convince them to convert to the ESG doctrine. Recent research on voting behavior of socially responsible mutual funds concludes that  “funds support ES proposals that are far from the majority threshold, while opposing them when their vote is more likely to be pivotal, consistent with greenwashing”.  The worst offenders are funds that exclude politically incorrect stocks and claim to make the world a better place.  If you eliminate an oil and gas company from your portfolio someone else who oes not care about the planet will buy it, so the world’s carbon footprint is not affected.

in the long run one would expect ESG funds to underperform, for the same reason that “sin stocks” are expected to outperform

Some would argue that there could be a beneficial effect via the cost of capital: if ESG funds become the dominant investors in green stocks the cost of capital of green companies will fall which will lead to more investment. The opposite will happen in the brown firms.  But as a lower cost of capital translates into a lower expected return on equity it means the claim that investors in ESG funds won’t give up returns is false as well. So, in equilibrium sin (brown) stocks will earn higher expected returns than green stocks.  The most recent empirical research shows that ESG funds may benefitted from “unexpected” positive returns as a result of ESG hype and inflows during the last 10 years, but in the long run one would expect ESG funds to underperform, for the same reason that “sin stocks” are expected to outperform. Moreover, ESG ratings have a huge industry bias: big tech companies get typically high ESG ratings and fossil fuel companies get low ESG ratings. When the first group underperforms and the second group ( consisting of coal stocks and oil and gas companies) outperforms as happened in 2022 investors in ESG funds will give up returns for a non-existing benefit (saving the planet).

So, what should regulators do ? A modest proposal would be to require every fund to put in the prospectus on the first page

-The money invested in the fund will not be received by the companies in the fund. So, the fund will not affect the carbon footprint of the companies in the fund

-Investors may have to give up returns because of a reduction in diversification and because the stock price of green stocks may reflect perceived non-monetary benefits .

Note that this regulation will not kill the ESG fund industry. Some investors may still want to invest in ESG funds because, as one of my colleagues put it, they may feel a “warm glow” from the perception that they are saving the planet.

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By Theo Vermaelen, Professor of Finance, INSEAD and ECGI Research Member. 

This article originally appeared in the INSEAD Knowledge blog

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