The False Promise of ESG Funds: Why They Fail Investors
While ESG investing promises both financial returns and societal benefits, it often fails massively on both fronts.
ESG investing funds claim to generate excellent returns while promoting environmental sustainability and social advancement. However, as the saying goes, if it sounds too good to be true, it probably is.
Environmental, Social, and Governance (ESG) investing has been touted as a remedy for the flaws of traditional capitalism, enticing investors with the promise of solid financial returns paired with societal benefits. Yet, a deeper look shows that ESG principles can harm investment growth, undermining the goals of individual investors. The widely accepted belief that ESG investing leads to benefits needs to be met with the cold reality of its adverse effects on investment portfolios and market efficiency.
The popularity of ESG investments has soared in recent years. According to Bloomberg Intelligence, the global assets managed under ESG criteria jumped to a staggering $35 trillion in 2020, with forecasts predicting this number could exceed $50 trillion by 2025. This impressive growth can be attributed to corporations’ efforts to polish their public image rather than pursue solid financial principles.
According to Harvard Business Review, “ESG funds certainly perform poorly in financial terms.” This claim is supported by a University of Chicago study on fund performance, which found that high sustainability funds didn’t outperform even the lowest rated funds.
The ineffectiveness of ESG funds is partially due to government regulations, which are becoming more restrictive by the day. The European Union’s Sustainable Finance Disclosure Regulation, which came into effect in March 2021, sets strict compliance rules for companies and investors, thereby increasing compliance costs and potentially limiting investment opportunities.
Inconsistency in ESG reporting and ratings also leads to inefficient investments. MIT Sloan’s research pointed out the moderate correlation of just 0.54 between different ESG score providers, significantly lower than Moody’s and Standard & Poor’s 0.92 correlation in credit ratings. This inconsistency could lead to confusion and asset mispricing, putting private investors at a disadvantage since they typically have less access to resources and are at a higher risk of being misled by unreliable ESG information.
Furthermore, ESG investing doesn’t even fulfill its promised sustainability goals. A Wall Street Journal article noted that ESG portfolios under-represent wind energy portfolios while investing in many major companies which don’t have strong ESG agendas. This growing challenge is known as “greenwashing,” where companies overstate their environmental efforts. A study by Quilter Cheviot showed that 44% of U.K. investors are wary about greenwashing in their ESG investments. Greenwashing causes portfolios to take the standard ESG reduced return while not assisting as many environmental efforts as advertised.
The concentration of power in the ESG investing landscape raises additional concerns about market manipulation and reduced competition. A small number of ESG rating agencies and fund managers wield disproportionate influence over investment decisions and corporate behavior. This consolidation of power can lead to homogenized investment strategies and potentially stifle innovation in the financial sector. Moreover, the subjective nature of ESG criteria allows these dominant players to shape market trends according to their interpretations, which may not always align with the best interests of individual investors.
The unintended consequences of ESG investing extend beyond individual portfolios to impact the entire economy. By diverting capital away from industries deemed less ESG-friendly, such as traditional energy or manufacturing, ESG investing may inadvertently hinder economic growth in developing nations that rely heavily on these sectors. Moreover, the emphasis on ESG metrics may incentivize companies to prioritize short-term, visible ESG improvements over long-term, substantive changes that could yield greater societal benefits.
The combination of inconsistent ratings, regulatory burdens, market distortions, and unintended economic consequences makes ESG funds a false promise for investors. Change must start with policymakers working towards creating a more balanced regulatory framework that encourages genuine sustainability without stifling economic growth or innovation. Companies, for their part, should prioritize transparent reporting and tangible improvements in their practices rather than chasing ESG scores. Only by moving beyond the current ESG model can we achieve a sustainable and prosperous future that balances financial returns with meaningful societal and environmental progress. The path forward lies not in rigid adherence to ESG criteria but in fostering a more holistic, nuanced approach to investing that serves individual investors and the broader global community.
