ESG investing: reliable science or rotten tomatoes? – Knowledge management
Rotten Tomatoes is an online movie review aggregator. When a film receives enough professional reviews, it gets a ranking, up to 100 on the “Tomatometer”.
You might be surprised to learn that the top-ranked movie on Rotten Tomatoes is Leave no trace. It received a score of 100% based on 251 reviews. You have not seen it ? You’re not alone. It did not bring in the US$3 billion that Avatar raked after scoring a much more lukewarm 82%.
So, Leave no trace is a big movie in the hearts and minds of critics, but if you were a movie producer, would you bet all your savings on it?
And here’s the catch. The most critically acclaimed films aren’t always the highest grossing. The same can be said for investing in decent companies: a company may have outstanding environmental, social and governance (ESG) scores, but still be the wrong investment for you if:
- This does not fit your time horizon. If it’s a relatively new company, its solution to a problem may still be decades away from development.
- This is outside of your risk tolerance.There is a chance it will be overshadowed by a yet to be discovered competitor.
- This does not match your current asset mix. It may be an equity investment, and your portfolio is based on fixed income solutions.
This is why every investment decision must balance two sets of numbers: financial on the one hand and ESG on the other.
The good news is that there is evidence to suggest that high ESG scores are often correlated with good management. And good management often leads to solid investment potential. But that’s not all, because ESG ratings do not replace the financial information used by analysts to assess companies, predict growth and determine risk.
ESG SCORES ARE SOMEWHAT SUBJECTIVE, AND THIS PRESENTS CHALLENGES FOR PEOPLE WHO PREFER STRONG FACTS OVER OPINIONS (LAWYERS, FOR EXAMPLE).
So is ESG a science, a sort of Rotten Tomatoes rating for investment enthusiasts, or something in between? To answer that question, we look at what’s not working so far, what’s working, and why the best days for ESG investing are likely to come for anyone who knows how to make sense of the scores.
WHAT DOES NOT WORK (YET)
ESG scores are somewhat subjective, which presents challenges for people who prefer hard facts to opinions (lawyers, for example). Every investor must recognize and accept the three current limits of ESG.
1. IT’S COMPLICATED
KPMG calls the long-term implications of today’s ESG choices “distant, fat-tailed risks that are difficult to model statistically, for lack of historical precedent.”1This means that we may never know the consequences of the trade-offs companies make to generate a good ESG score. For example, closing a factory may be good for the environment (E) but bad for the local economy (S). It could take decades to see the full effect of the decision.
2. THIS IS NOT CONSISTENT
The Economist magazine recently suggested: “ESG has a measurement problem: the different rating systems have gaping inconsistencies and are easily manipulated.”
Accounting firms around the world benefit from longstanding traditions and practices summarized by the International Accounting Standards Board (IASB). Until 2021, there was no such standardization for ESG reporting agencies.
This changed with the launch of the International Sustainability Standards Board (ISSB). According to its website, its mission is to provide a comprehensive global baseline of sustainability-related disclosure standards. That’s good news for anyone who cares about ESG scores, but it’s just the beginning.
3. IT HAS A LIMITED RANGE
Publicly listed companies are rated, but private companies have a choice. That sounds fine, except that 83% of Canadians work for small and medium-sized companies that don’t have to be ESG rated. A private company, such as one that supplies auto parts to a car manufacturer, may choose to be rated in the hope that a good score will help it win contracts or improve its reputation. In any case, it remains voluntary for private companies.
With all of these challenges, ESG rating systems may never achieve the same level of consistency as financial reporting standards. They may continue to be something closer to a movie review than an audit report.
But that’s not entirely bad news.
SO WHAT IS WORK?
Roland Sakha, Chief Investment Officer, Global Private Wealth at Fiera Capital, Lawyers Financial’s Private Wealth Partner, acknowledges the limitations of ESG scores, but remains optimistic about what works:
“The biggest thing that’s come out of responsible investing and ESG movements so far is that we’re having discussions about things that weren’t talked about 20 or 30 years ago. Speaking of ESG risks , we’re advancing the conversation about social responsibility and innovation. Indirectly, that’s how ESG is going to help us solve global problems. And that’s good news for everyone.
Senior Investment Advisor at Fiera Capital, Paul de la Roche, echoes Sakha’s optimism about the future of ESG decision-making:
“When a client expresses a desire to make responsible investments, we can work with them to fine-tune a portfolio to achieve very specific goals. This can be as simple as choosing a passively managed ESG mutual fund or as detailed than applying complex filters to each decision. ESG data allows us to offer greater personalization based on a client’s desire to be a more responsible investor.”
ADD ESG TO YOUR PORTFOLIO IN A THOUGHTFUL AND MEASURED WAY
For investors looking to use ESG scores to build responsible financial plans, the Fiera Capital team has some great advice.
1. STAY BASIC
Before adding any type of ESG investing to your financial plan, make sure it meets the requirements of your investment policy statement (IPS). With so many options for mutual funds and exchange-traded funds (ETFs), it gets easier every day. Smart investing aligns with your goals, time horizon and risk tolerance.
If it’s been a while since you’ve updated your SPI, consider reviewing your goals with your financial advisor and discussing how to incorporate ESG strategies.
2. CHOOSE THE RIGHT ESG INVESTMENTS
Not all ESG investment options are created equal. Some may lean more towards sectors, regions or types of technology. Others actively exclude specific types of investments, such as weapons.
Some seek to invest capital in businesses that have good long-term prospects of impacting the world (impact investing), but may not be suitable for short-term goals such as revenue generation . Work with your advisor to make sure the investments you choose complement the rest of your portfolio so your overall asset mix stays aligned with your goals.
3. SET YOUR EXPECTATIONS
De la Roche encourages clients to set their expectations when it comes to balancing investment performance with financial results. “Many socially motivated investors recognize that change takes time, and they set realistic goals based on what they hope to achieve as an investor and as a proponent of ethical decision-making.”
WE CAN HELP.
Invest purposefully with the help of your wealth management team at Lawyers Financial. CBIA/Lawyers Financial is a not-for-profit organization that provides free financial planning to all members of the legal community in Canada. Start with a 30 minute conversation about your needs, goals and expectations, and we’ll help you get started.
The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.