Is ESG Investing a Good Approach? Perhaps, But There Are Pitfalls

Investing in companies that are leaving a positive impact on the world is something just about all of us can get behind. After all, who wouldn’t want to back businesses that are driving us toward a better future?

In recent years, ESG, or environmental, social and (corporate) governance investing has taken off, largely due to high investor demand.

This approach, while still focusing on fundamental analysis, places an extra emphasis on a business’ impact on the environment and social issues as well as ethical corporate decision-making.

And while it’s great to see the industry shift to morally conscious investing, there are very real pitfalls investors should be aware of.

Image source: Getty Images.

Consider three of the biggest ESG traps and how to navigate around them:

Greenwashing

Companies will often try to capitalize on the demand for environmentally conscious products and services by touting their sustainability without ever backing up their claims with measurable results.

This is known as greenwashing, and unfortunately, it’s prevalent today.

For example, in 2018, Nestlé made a claim that it would use 100% recyclable or reusable packaging by 2025. The press release failed to include any specifics on how the company would accomplish this, and the terms recyclable and reusable are not regulated and have varying definitions.

Since making that claim, the food and beverage company made the top four in a list of worst global plastic polluters for four straight years, according to audits conducted by the environmental organization Break Free from Plastic.

While it’s possible the company is making real sustainability improvements, the lack of details and the continued pollution of the world’s oceans and waterways indicates the announcement was likely an empty one designed to make consumers and investors feel better about their purchase.

If you’re serious about owning sustainable businesses, it’s imperative you do your own research instead of taking companies at their word. Here are some useful resources:

MSCI and Sustainalytics are the two most-widely recognized ESG rating agencies.
Ethical Consumer offers free sustainability reports on over 40,000 companies and products.
The Secretary of the Senate publishes Lobbying Disclosure Act (LDL) Reports where you can track corporate lobbying to see if it aligns with sustainability statements.

Investing solely off ESG ratings

ESG ratings are a great way to get a 50,000-foot view of the company’s overall efforts. But investors need to dig further if they want their portfolio to include companies that are truly making a positive impact on the world.

For example, Coca Cola Co.‘s single-use plastic production is responsible for more pollution than any other company in the world, and yet it’s MSCI rating is AA, which makes it an “ESG leader.”

This example demonstrates the shortcomings of rating agencies when used as a single determinant of overall ESG quality. While Warren Buffett’s favorite beverage company is without a doubt a high-quality business, it’s hard to see how it can be labeled an ESG leader.

And this wouldn’t be the first time a rating agency’s evaluation was less than accurate.

Leading up to the 2008 housing crash, the major bond rating agencies erroneously appraised many of the problematic mortgage-backed securities as extremely low risk when they were in fact full of faulty subprime loans.

That may not be an apples-to-apples comparison, but it highlights the problematic nature of relying solely on rating firms for a measurement of quality.

Buying ESG funds

ESG mutual funds and index funds seem like an easy way to gain exposure to ethical businesses. The problem is they are typically built by looking at top-performing, non-ESG funds and then reducing the exposure to companies with the worst ESG ratings.

So, while investors might be thinking they own slices of the most ethically and socially conscious companies, they probably just own less of the worst. For example, the Blackrock Sustainable Advantage Large Cap Core Fund which is “focused on sustainable ESG characteristics” has ExxonMobil among its top 10 holdings.

Peter Krull, chief executive officer of Equity Earth Advisors, recently wrote the following in a Kiplinger article:

“An ESG portfolio that reduces its allocation in ExxonMobil is less bad. A portfolio that eliminates it entirely is better, but a portfolio that buys First Solar in its place is both sustainable and responsible.”

Unfortunately, right now a lot of ESG funds are just “less bad.” If investors decide to go the fund route, it’s incredibly important to look under the hood at the underlying investments to see if the portfolio is built around ethical business practices or simply one that removed some bad apples.

Invest in companies that demonstrate ESG

In my opinion, the best way to invest sustainably is to directly buy the stock of companies with ethical missions and culture as well as a track record of backing it up with measurable results. For investors serious about ESG, the goal shouldn’t be to buy companies that say they are environmentally and socially ethical, but rather ones that show you how they are doing that.

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Mark Blank has no position in any of the stocks mentioned. The Motley Fool recommends First Solar and recommends the following options: long January 2024 $47.50 calls on Coca-Cola. The Motley Fool has a disclosure policy.

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