Why NOT to Invest in ESG Funds?

Abstract

We review the ESG ETF sector with respect to alignment with ESG principles, stock selection strategy, and characteristics of selected stocks. First, we find no evidence that ESG funds invest in a manner that is aligned with the principles of ESG. Instead, ESG funds exhibit stock weightings that are comparable to the stock weighting within the S&P 500 index; suggesting that ESG funds are closet indexers. Second, ESG funds select stocks that have high current ESG scores; this selection strategy favors sectors which have inherently high ESG characteristics, such as technology and financial services, and overlooks sectors with inherently lower ESG scores, such as transportation or manufacturing. Third, connected to the first two findings, we also find that ESG funds favor stocks with low cost of capital, that is, high price earnings ratio; this practice ignores companies with high cost of capital, such as utilities, that play a major role over the long term in the transition to an ESG aligned economy. In consequence, we recommend that investors with an interest in social goals do not invest in ESG funds, because these funds are misaligned with the principles of ESG and, furthermore, investing in ESG funds diverts capital away from companies with the highest potential for positive change through ESG practices.

Keywords: ESG funds, energy transition, cost of capital, societal outcome, reward versus incentive methodology.

JEL Classification: Q01 G10 G12