ESG Investing Is A Billion Dollar Sham Industry

Adam Wren
DataDrivenInvestor
Published in
13 min readAug 13, 2022

Apparently millennial investors like me have different values from those of previous generations. These values have been Acronym’d by the financial industry into ESG (Environmental, Social and Governance).

The premise of ESG is that investors want to put their money into green energy, ‘clean technology’ and socially responsible companies, and so a billion-dollar industry has risen around this ESG metric. Rating agencies evaluate companies according to their environmental/social impact and give them ‘ESG ratings’, companies are hiring ‘ESG analysts’ and financial institutions are launching ‘ESG Funds’ for the ethically minded investor.

It’s been around for awhile, but it’s recently started rapidly developing: LinkedIn currently returns 3000 results for ‘ESG Analyst’ in London alone, Bloomberg predicts that by 2025 ESG managed assets will hit $53 trillion, a third of all managed assets globally.

For investors that care about the environment and the social impact of their capital this sounds great, optimistic even, until you look under the hood and learn that ESG is at best misleading and at worst — an outright scam.

I know that’s a bold claim, follow along with me -

ESG Scores

Part of the reason younger investors want to invest in environmentally minded companies are ethical concerns about the damage corporations are doing to the planet.

The second most compelling reason is that we can see the writing on the wall with regards to the energy transition and the growth opportunities of the ‘energy transition’:

At some point this century we are going to hit a point where the cost of extracting a barrel of oil from the ground costs more than burning it produces. Estimates vary from between 2040–2088, but even ignoring climate change and global warming, we really are running out of easily accessible resources. (No new large oil fields have been discovered since 1988, and no significant deepwater finds since 2012)

Source: MAHB @ Stanford

This is the crux of the ‘energy transition’. We’re going to have to transition 725 Exajoules (EJ) of fossil energy generation (2050 estimate) to a combination of renewables/nuclear. It’s a tall order, but achievable. The IEA estimates that the electricity production of renewables will surpass coal by 2025.

A McKinsey report states that by 2050:

nonhydro renewables will account for more than a third of global power generation — a huge increase from the 2014 level of 6 percent. To put it another way, between now and 2050, wind and solar are expected to grow four to five times faster than every other source of power.

If you’re a young, ethically minded investor seeking growth, this is fantastic news. On a decades-long timeframe the growth of renewable energy and ‘green tech’ is all but assured. This means that ‘ESG Investing’ seems like it would be a fantastic way to identify and profit from the companies that are best positioned to develop from the transition as this new market develops.

Except that isn’t what ESG scores do.

Consider Tesla -

The valuation of Tesla has been a hot topic for the past few years, analysts will point out that it is worth more than every other car manufacturer combined, despite making up less than 1% of vehicle sales globally.

Others think the valuation is justified because of it’s unique market positioning: Almost every car manufacturer has committed to moving towards a fully electric fleet in the coming decades and Tesla is currently the market leader in electric vehicle sales. In the “battery only” electric vehicles category, Tesla sold more than the next two competitors combined.

Tesla has what in business we would call a ‘Moat’ — It has a competitive edge that is going to be difficult, or at least -very expensive- for its competitors to overcome. Ford, VW, Toyota and other manufacturers sell more vehicles currently, but as the market transitions to fully electric their present manufacturing capacities are going to take billions to refit and retool for electric production. These companies are going to have to undergo the largest transition in their history. Tesla doesn’t have this problem, it’s ready for the future market right now.

This must mean Tesla has a good ESG score, right?

Well, no.

Sustainalytics gives Tesla an ESG score of 28.6. It’s ranked 42 out of 83 in the automobiles sector, being beaten by the likes of Mercedes-Benz at 22.1 (lower being better).

Why is this?

This article published in February 2022 by the GRC World Forum suggests that the reason for the low ESG score is due to Elon Musk, or more accurately — the analysts opinions of Elon.

The author notes:

For transparency, labor relations, adherence to governance, for example, having a CEO who doesn’t send out random tweets, Tesla scores poorly

[Tesla’s 2019 impact statement] “was not exactly a statement that endeared Tesla to those who create ESG scores”

The author is suggesting that ESG scores are largely influenced by opinion, something that hasn’t gone unnoticed at Tesla:

Musk is correct about the oil companies here, two oil companies (OMV AG: 27.4 and Repsol: 26.4) both have better scores than Tesla.

The key problem here is that E,S and G are all weighted equally, while not close to being equal in practice. E can be quantified, while S and G are entirely subjective. The equal weighting of each metric means that companies outstanding in one area are beaten out by seemingly much worse companies overall because of the other two dimensions.

The scores also don’t account for the wider impact that a company might have had, for example Tesla isn’t given get credit for helping to push other automakers towards EV’s. Regardless of how you feel about Tesla or Musk, it’s undeniable that had tesla not proved profitably and consumer demand, the EV market would not be as developed as it is today.

This is most egregiously demonstrated by the fact that Tesla has been dropped from the S&P 500 ESG Index for concerns about their working environment after being sued in a racial discrimination lawsuit.

You might agree that this is the correct course of action, if so, you will also likely agree that Amazon should be dropped after being sued for telling it’s employees to work through a severe weather warning, resulting in six of them being killed after the building was hit by a tornado, yet amazon remains the funds third largest holding.

You might also disagree that Nestle, a company that was sued earlier in the year for profiting from child slavery be given a 4.9 rating by FTSERussel and subsequently included in the FTSE4Good Index which claims it’s purpose as:

a market-leading tool for investors seeking to invest in companies that demonstrate good sustainability practices. It also supports investors that wish to encourage positive change in corporate behavior and align their portfolios with their values.

So, the scores are arbitrary and subjective but they work right? Afterall there are frequent claims by the ratings agencies that ESG scores correlate well with performance and ESG funds were on a good run for awhile.

But this doesn’t make intuitive sense. It seems obvious that focusing on a different aim would deliver different results. Investing for anything other than raw profitability or growth should naturally reduce the overall profit potential for any given investment. So how can these ratings agencies claim that there’s a positive relationship between ESG scores and market performance?

Well, it’s being faked:

This study from MIT Sloan shows that there are “widespread and repeated” retroactive changes to ESG scores by ESG ratings agencies in order to establish this relationship.

He explains that the data for any specific point in time should remain the same for a firm unless there is a documented reason for a retroactive change. However, their study revealed significant unannounced and unexplained changes to the data provided by Refinitive ESG, which was previously owned by Thomson Reuters. For example, looking at two versions of the same Refinitive ESG data for identical firm years — one from September 2018 and the other from September 2020 — the median overall scores in the rewritten data were 18% lower than in the initial data.

He notes that the data rewriting occurs on an ongoing basis without any public announcements. To show this, the researchers compared ESG scores from February 9 and March 23, 2021 — just six weeks apart — and found that 85% of firms’ scores changed. While the score changes were mostly small in magnitude, the ongoing retroactive changes affected the classification of firms and the link between ESG scores and returns.

So the ratings agencies have been altering ESG data in order to establish a positive relationship between between ESG scores and market performance.

They do this because claiming a positive relationship means the data becomes valuable and financial institutions are willing to purchase it for millions of dollars. Does that mean that these ESG funds have been cheated? Afterall if the data they are buying is being altered they should be underperforming the market right? As the above paper states:

Using predictive regressions, they showed that investing in firms with higher ESG scores in the initial data would not have led to economically or statistically significant performance gains. Yet, in the rewritten data, they found economically large, statistically significant positive effects of the E&S score on the firm’s future stock returns. These large differences matter because this performance would not have been possible with the data available to investors when forming their investment strategies.

Yet we know this isn’t the case. As stated earlier, some of these funds actually performed quite well. How can they be beating the market with unreliable data?

Let’s take a look.

The Funds

Let’s examine the top holdings of some of the largest ESG Funds:

╔═══════════════════════════════╦═════════════╦════════════════╗
║ Parnasus Core Equity Fund ║ ║ ║
╠═══════════════════════════════╬═════════════╬════════════════╣
║ Company Name ║ # of Shares ║ Market Value ║
║ Microsoft Corp. ║ 6,672,446 ║ $1,873,222,490 ║
║ Alphabet Inc., Class A ║ 13,438,880 ║ $1,563,210,522 ║
║ Fiserv Inc. ║ 10,884,686 ║ $1,150,293,616 ║
║ Danaher Corp. ║ 3,800,882 ║ $1,107,843,077 ║
║ CME Group Inc., Class A ║ 5,062,381 ║ $1,009,843,762 ║
║ Becton, Dickinson and Co. ║ 4,131,668 ║ $1,009,407,809 ║
║ Mastercard Inc., Class A ║ 2,735,121 ║ $967,658,459 ║
║ S&P Global Inc. ║ 2,542,234 ║ $958,244,262 ║
║ Deere & Co. ║ 2,792,238 ║ $958,240,237 ║
║ Canadian Pacific Railway Ltd. ║ 11,182,599 ║ $881,971,583 ║
║ Apple Inc. ║ 5,327,965 ║ $865,847,592 ║
║ T-Mobile US Inc. ║ 5,597,835 ║ $800,826,275 ║
║ Comcast Corp., Class A ║ 21,336,057 ║ $800,528,859 ║
║ Linde plc ║ 2,474,530 ║ $747,308,060 ║
║ Verisk Analytics Inc. ║ 3,832,206 ║ $729,077,192 ║
║ The Procter & Gamble Co. ║ 5,039,444 ║ $700,029,166 ║
║ Adobe Inc. ║ 1,643,676 ║ $674,104,401 ║
║ American Tower Corp. ║ 2,445,771 ║ $662,388,160 ║
║ The Charles Schwab Corp. ║ 9,497,745 ║ $655,819,292 ║
║ Waste Management Inc. ║ 3,971,331 ║ $653,522,229 ║
╚═══════════════════════════════╩═════════════╩════════════════╝
╔════════════════════════════════╦═══════════════╦═══════════════╗
║ iShares ESG Aware MSCI USA ETF ║ ║ ║
╠════════════════════════════════╬═══════════════╬═══════════════╣
║ Company Name ║ # of Shares ║ Market Value ║
║ APPLE INC ║ 10,183,521.00 ║ 1,723,459,094 ║
║ MICROSOFT CORP ║ 4,790,338.00 ║ 1,385,174,136 ║
║ AMAZON COM INC ║ 5,695,085.00 ║ 812,631,678 ║
║ TESLA INC ║ 563,003.00 ║ 497,171,059 ║
║ ALPHABET INC CLASS A ║ 3,631,660.00 ║ 434,709,702 ║
║ ALPHABET INC CLASS C ║ 3,503,830.00 ║ 422,737,089 ║
║ NVIDIA CORP ║ 1,739,680.00 ║ 314,829,889 ║
║ JPMORGAN CHASE & CO ║ 2,155,049.00 ║ 255,136,251 ║
║ UNITEDHEALTH GROUP INC ║ 449,695.00 ║ 241,809,995 ║
║ HOME DEPOT INC ║ 770,936.00 ║ 240,208,238 ║
║ META PLATFORMS INC CLASS A ║ 1,302,665.00 ║ 232,317,276 ║
║ JOHNSON & JOHNSON ║ 1,340,331.00 ║ 228,754,291 ║
║ VISA INC CLASS A ║ 1,062,193.00 ║ 225,291,135 ║
║ PEPSICO INC ║ 1,250,536.00 ║ 220,019,303 ║
║ EXXON MOBIL CORP ║ 2,368,352.00 ║ 216,585,790 ║
║ COCA-COLA ║ 3,288,716.00 ║ 209,326,773 ║
║ PROCTER & GAMBLE ║ 1,420,573.00 ║ 207,829,829 ║
║ MASTERCARD INC CLASS A ║ 553,140.00 ║ 195,468,613 ║
║ ADOBE INC ║ 420,355.00 ║ 184,283,632 ║
║ TEXAS INSTRUMENT INC ║ 940,481.00 ║ 172,220,880 ║
╚════════════════════════════════╩═══════════════╩═══════════════╝
╔══════════════════════════════╦═════════════╦══════════════╗
║ S&P 500 ESG ETF ║ ║ ║
╠══════════════════════════════╬═════════════╬══════════════╣
║ Company ║ # of Shares ║ Market Value ║
║ Apple Inc ║ 464,390 ║ 78,593,363 ║
║ Microsoft Corp ║ 225,884 ║ 65,316,617 ║
║ Amazon.com Inc ║ 264,490 ║ 37,740,078 ║
║ Alphabet Class A ║ 181,625 ║ 21,740,512 ║
║ Alphabet Class C ║ 166,524 ║ 20,091,120 ║
║ UnitedHealth Group Inc ║ 28,300 ║ 15,217,476 ║
║ NVIDIA Corp ║ 75,650 ║ 13,690,380 ║
║ Exxon Mobil Corp ║ 127,246 ║ 11,636,646 ║
║ Procter & Gamble Co ║ 72,501 ║ 10,606,896 ║
║ Visa Inc-Class A Shares ║ 49,836 ║ 10,570,215 ║
║ JPMorgan Chase & Co ║ 88,892 ║ 10,523,923 ║
║ Mastercard Inc-Class A ║ 25,921 ║ 9,159,962 ║
║ Pfizer Inc ║ 169,592 ║ 8,471,120 ║
║ Coca-Cola Co ║ 117,753 ║ 7,494,978 ║
║ AbbVie Inc ║ 531,32 ║ 7,488,424 ║
║ Bank of America Corp ║ 213,401 ║ 7,483,973 ║
║ Pepsico ║ 41,516 ║ 7,304,325 ║
║ Lilly (Eli) & Co ║ 23,859 ║ 7,267,689 ║
║ Thermo Fisher Scientific Inc ║ 11,840 ║ 7,013,424 ║
║ Merck & Co Inc ║ 76,403 ║ 6,814,383 ║
╚══════════════════════════════╩═════════════╩══════════════╝

As you can see, these funds are mostly weighted towards tech and industrials, not exactly the first thing that comes to mind when you think of ethical investing, to say nothing of the inclusion of ExxonMobil in two of those funds.

An MSCI analysis of the top 20 ESG funds showed -

Sector exposures across the funds revealed that information technology was the largest allocation in most funds, and an almost zero allocation in energy. This was one of the key drivers behind the shorter-term recent outperformance of ESG funds relative to their non-ESG counterparts, as tech stocks rallied in 2020 whilst energy declined.

So the overperformance of ESG funds compared to a wide index was because they are tech heavy.

Google was the most commonly held stock across most funds; Alphabet Inc. was in 12 funds, with an average weight of 1.9% . The companies with the highest average weight across the funds were Apple (5.6%) and Microsoft (5.0%)

So ESG funds are basically investing in the same things that most other funds do: Tech (FAANG) and industrials, with very little, if any allocation towards energy. This is permissible by their rules because all of these companies have good ESG scores. Afterall their CEO’s don’t tweet.

This raises a worrying question — if ESG ratings are only showing a positive relationship with returns because of retroactive editing of data and “ESG-focused funds” are investing in the same types of equities that you would find in a normal fund why does this billion dollar industry exist?

The simple answer lays in these three graphs:

Source: Morningstar

The easy accessibility of financial knowledge on the internet has allowed retail investors to learn that actively managed funds mostly underperform passive index funds.

Prevailing wisdom for the last decade has been for investors to consistently buy the index.

The has meant the last decade has seen a steady increase in capital away from actively managed funds and into passive index funds and ETF’s:

Source: cabotwealth
Source : Morningstar

The assets of equity index funds surpassed actively managed funds in 2019.

Largely driven by younger (millennial and gen z) investors, who don’t want to pay fees for below market returns.

The prospects for fund managers being able to attract young investors were not looking particularly positive until they found a new target:

The Socially Conscious Investor.

The socially conscious investor knows that active funds underperform but might have some reservations about investing into an index.

If you buy into an index fund, you’re investing into everything the index tracks, some of which you might not want to own, whereas an ESG fund shouldn’t have any companies that people find ethically questionable.

For example, you probably wouldn't expect to find ESG funds containing:

Heavily polluting oil majors like Exxon:

╔════════════════════════════════╦══════════════╦════════════════╗
║ iShares ESG Aware MSCI USA ETF ║ ║ ║
╠════════════════════════════════╬══════════════╬════════════════╣
║ Company Name ║ # of Shares ║ Market Value ║
║ EXXON MOBIL CORP ║ 2,368,352.00 ║ 216,585,790.40 ║
╚════════════════════════════════╩══════════════╩════════════════╝

Or weapons manufacturers like Raytheon:

╔════════════════════════════════╦══════════════╦══════════════╗
║ iShares ESG Aware MSCI USA ETF ║ ║ ║
╠════════════════════════════════╬══════════════╬══════════════╣
║ Company Name ║ # of Shares ║ Market Value ║
║ RAYTHEON TECHNOLOGIES CORP ║ 1,413,521.00 ║ 132,051,131 ║
╚════════════════════════════════╩══════════════╩══════════════╝

ESG funds are largely investing in the same ways that ‘standard’ funds do. This is allowed because the structuring of the ESG metric and the altering of data by ESG ratings agencies means that fund managers are able to invest in whatever they would like.

If the ESG rating of one provider doesn’t allow them to invest in the way they would like — they can simply choose another that does.

How many investors are going to look into how ESG scores are derived or what these funds are actually buying?

The entire point of third party ratings is that the average investor doesn't have to concern themselves with it. The judgments are abstracted away from them.

The marketing of ESG scores and ‘green finance’ likely means that most investors are trusting these funds to invest their money in ways that:

encourage positive change in corporate behavior and align their portfolios with their values

Which is probably why most of the money flowing into ESG is going into active funds:

Source: MCSI

Actively managed funds, and their fund managers salaries were being threatened by younger, savvy investors that might have otherwise invested into a passive index funds.

These funds have figured out a way to not only bring younger investors on board, but also charge an average 43% higher fee for ESG funds than for regular funds. It would be a very impressive feat of marketing if it wasn’t so deceptive.

I’m an ethically-minded millennial investor. Instead of investing in an ESG fund I'm going with the optimal investment method of consistently buying into a passive index and then donating a portion of my gains to charity.

I’ll do more good for the world and I'll keep my money out of the hands of scammers and thieves.

If you liked this: follow me here on medium or my new substack where I intend to focus on the intersections of the environment, politics and finance.

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