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Better governance, oversight give reasons to remain optimistic about the future of ESG investing

·4 min read
Trading On The Floor Of The NYSE As Stocks Drop While Investors Turn on Banks
Trading On The Floor Of The NYSE As Stocks Drop While Investors Turn on Banks

Over the past two decades, environmental, social and corporate governance (ESG) investing has enjoyed a rapid rise in popularity with more and more investors deploying their capital in pursuit of not only better returns, but a better world.

ESG investing has grown into a US$35-trillion practice globally, but market volatility, buffeted by rising interest rates, geopolitical uncertainty in Europe, global supply chain challenges and fears of an impending economic recession, have not spared ESG funds.

After years of net new deposits, investors withdrew US$3.5 billion from ESG mutual funds in the United States in May 2022, marking the first quarter of outflows in more than five years. In Canada, the iShares ESG Advanced MSCI Canada Index ETF — an ESG index by BlackRock Inc. — is underperforming the S&P/TSX composite by seven per cent year to date.

Of course, market conditions have not been kind to most equities and sectors, but bad returns have also been compounded by mounting allegations of industry malpractice and inaccurate labeling of ESG funds. This difficult year for ESG investing has served as a wake-up call, with concerted efforts now being made to better inform investors on what sustainability practices are being applied.

Thankfully, this has also sparked meaningful action across market regulators and investors, giving reason to remain optimistic about the future of the ESG movement. The industry will need time and improved governing structures to address its issues, but reform from both governments and institutional investors alike is a great cause for optimism.

For example, new European Union regulations are forcing funds that want to use the ESG label to disclose how their strategies address environmental, social or governance issues. No such regulation exists in North America, but the U.S. Securities and Exchange Commission and the Canadian Service Administrators are lobbying for enhanced reporting on ESG measures.

Knowledge and access are key to ESG investing. A common critique of ESG funds is whether managers screen for ESG metrics or if they only consider ESG principles on a high level.

For example, many investors are surprised to learn that there are ESG exchange-traded funds (ETFs) that hold oil and gas companies. This is a result of the “best-in-class approach,” which is the process of selecting companies from various sectors, such as oil and gas, that obtain a higher ESG rating than their competitors.

A particularly shocking example of this practice was when Tesla Inc., a pioneer in the adoption of electric cars, was removed from the S&P 500 ESG Index, while hydrocarbon giant Exxon Mobil Corp. remained on the index.

Another common example of greenwashing in the industry is “screening,” which occurs when fund providers omit so-called sin stocks, such as tobacco and weapons, as a strategy to justify an ESG tag on their funds.

Increased government intervention and regulations will provide greater transparency in relation to the methodologies and reporting standards that funds are using, and will ultimately help investors understand whether a fund’s underlying investments correspond with its ESG label.

Along with the ongoing regulatory campaigns pushing for enhanced disclosures on ESG measures, investors are also demanding more action from companies. A notable example was the 2021 campaign by Engine No. 1 LP, a U.S. hedge fund that only held a 0.02-per-cent stake in Exxon Mobil yet successfully ousted three members of the company’s board of directors in favour of replacements who were more committed to combating climate change.

This David and Goliath story exemplifies a growing wave of active engagement from investors. Instead of simply withdrawing money from one place to invest in another, investors are engaging directly with corporate leadership to strategically wield the power of shareholder voting to effect change.

We can expect to see this trend continue. In Canada, the Ontario Teachers’ Pension Plan Board has announced plans for the $242-billion fund to buy more controlling stakes in companies so that it can keep a closer eye on ESG performance.

As an investment adviser, I serve clients by listening to their needs, goals and values, while ensuring that our industry is well versed in the constant changes that define ESG investing. That is why it is important to speak to an investment adviser who will provide you with a holistic approach to ESG investing based on your unique needs and situation.

Before making any investment decision, determine what goal or cause is important to you. Think of your long-term convictions and which of them would be a powerful way to feel less uneasy about market volatility.

The issues ESG investing faces are the growing pains of an evolutionary process, not a feature. There is so much more to be written in the history of ESG investing and I believe that the next chapters will be filled with opportunities for the engaged investor.

Andrew Feindel is a portfolio manager at Richardson Wealth and author of Kickstart Your Corporation: The Incorporated Professional’s Financial Planning Coach.

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