Investing In ESG-focused Mutual Funds: Should The SEC Crack Down?

In the mid-1990s, regional mutual funds increased across the United States. Today, global areas come to mind when considering a “regional” fund. However, thirty years ago, a “regional” fund might also have referred to so-called “cheerleader” funds that advocated a state in whole or part.

Consider these as initiatives that the local Chamber of Commerce may support. These subsidies were intended to promote the community’s social welfare. The SEC required these funds to explain the criteria for possible investments in detail, including the geographic footprint (whether by state or county) and how security would qualify for inclusion in that geographic region.

Similarly, roughly a decade earlier, “SRI” funds emerged. This sort of “Socially Responsible Investing” was primarily, but not entirely, used to encourage investing in anti-Apartheid firms and specify which companies were eligible for investment.

Over time, these funds diminished as investors favored bigger returns over perceived moral convictions or even the improvement of their communities.

Today, a significant marketing phenomenon known as “ESG” exists. This initiative prioritizes “environmental,” “social,” and “governance” considerations in product evaluation and purchase choices. Among these are investment decisions.

When “marketing” and “investment” are combined, the danger of deceiving investors increases. Possibly, for this reason, the SEC indicated last spring that it would review disclosure rules for funds offering themselves under the ESG banner. ESG includes a wide range of assets and strategies, according to Gary Gensler, chairman of the Securities and Exchange Commission. He believes investors should be allowed to examine these schemes’ inner workings, which is the essence of the SEC’s mandate to safeguard investors.

Given the present misunderstanding surrounding ESG, the SEC may consider restricting the word “ESG” in prospectuses and other marketing materials for mutual funds.

Terry Morgan, the president of Ok401k in Oklahoma City, states that the problem cannot be resolved. ESG is the most un-American, toxic, and unclear investing philosophy since subprime mortgages back CDOs.

Does ESG investment have a genuine impact?

However, ESG appeals to the conscience of the investing public. Over the past decade, according to Morningstar, the number of mutual funds has surged fivefold (ending in 2021). More impressively, the value of assets has increased by more than fourfold during the past three years.

However, does ESG investment make a difference?

Sanjai Bhagat, the University of Colorado’s Provost Professor of Finance and author of Financial Crisis, Corporate Governance, and Bank Capital, cited research conducted by the University of Chicago based on Morningstar sustainability ratings in a recent article published by the Harvard Business Review: The highest rated funds, in terms of sustainability, attracted more capital than the lowest rated funds. None of the high sustainability funds outperformed any of the low sustainability funds.

Performance alone is insufficient to determine the value of an ESG fund. Investors typically desire to make a statement with their investments.

Is this assertion being made?

Mark Neuman, CIO, and Founder of Atlanta-based Constrained Capital, which just launched the ESG Orphans ETF (ORFN), stated, Seventy to eighty percent of ESG funds hold Amazon (AMZN). Amazon has the largest global carbon footprint and third-largest holding at Blackrock’s and Vanguard’s ESG flagships.

It’s not only well-known technology businesses, and Long-vilified stocks frequently rank highly in sustainability evaluations. Philip Morris has a higher Environment Risk Score than Tesla, according to Sustainalytics, says Jason R. Escamilla, Founder and Chief Investment Officer of San Francisco-based ImpactAdvisor. The same might be said of Big Sugar.

On this final issue, Neuman agrees. He states Nuveen’s Large Cap ESG Fund favors dividends above ESG, as Coke and Pepsi are its two largest holdings. Type-2 diabetes and obesity cost our nation over $1 trillion yearly, school vending machines are stocked with sugary sodas, and soft drinks produce ecologically unfriendly plastic bottles.

Consider how this similar “extension of concept” arises in other investment disciplines before passing judgment.

Mark Sievers, president of Epsilon Financial Group, Inc. in Fairfield, California, explains this is a comparable issue to other ways, such as when value investing migrates to stocks that are not valued or are valued only by some fairly unusual definition.

What are ESG’s disadvantages?

Such contradictions have investors questioning if the ESG industry has lost its luster. It is logical to question why fossil fuel corporations have sprung up in ESG funds in recent years.

Harold Evensky, founder of Evensky & Katz in Lubbock, Texas, says, “ESG Funds—’ Environmental, Social, and Governance’—sounds nice, but have you ever tried spreading principles on a cracker?” “It doesn’t work.” First, without precise criteria, the portfolio’s contents are unknown, and you may purchase a pig in a poke. Moreover, returns may be quite variable. Just look at the 1-year results of the Gabelli ESG Fund, and the returns of the ten largest holdings varied between -0.75% and -36%. Lastly, expenditure ratios for ESG investments tend to be rather high.

You should not stress performance with ESG since you are not choosing assets based on financial analysis; you are choosing investments based on your philosophy. Ironically, the improved performance returns of recent years may have spoilt ESG investors.

The main difficulty is that no ESG fund can guarantee to outperform the market, Sievers explains. Investors must recognize the tradeoff by incorporating their preferences into their investment decisions. There is a price,

The performance of one of the oldest SRI/ESG funds, the Ave Maria flagship fund, has trailed below its standards over the past decade.

Religious funds may be more SRI than others because they tend to give investors the truth. An example would be the Islamic financing vehicles that know returns would be lower than non-Islamic funds since there is a penalty to being moral, which investors are aware of beforehand, explains Neuman.

There is, of course, a positive aspect to bad performance. When managers underperformed the profit projections (given by analysts tracking their firm), they frequently stressed their commitment to ESG, Bhagat noted.

Are ESG funds a good investment?

In particular, the terminology associated with ESG has grown so vague that they no longer have any meaningful significance.

Neuman states, There is no unanimity on anything ESG, and there is no precise technique to quantify the E, S, and G as components or as a total. The solution is for all ESG funds to communicate the truth: You can do good with your ESG investments, but at the cost of reduced returns, and the goals may not be realized.

Similar to how SRI developed into ESG, it is likely that ESG, once it has run its course, may evolve into something new that answers some of the major flaws.

According to Escamilla, ESG/Impact/Responsible Investing is still in its infancy. ESG’s greatest fault is the absence of a unified definition; the notion represented by the letters ‘ESG’ is interpreted differently by investing experts, legislators, everyday investors, and Elon Musk. Tesla has been the most influential factor in the move to electric vehicles for decades. But the company’s poor ‘G’ and ‘S’ ratings disqualified it from the S&P 500 ESG index.

Of course, many feel that Tesla’s exclusion from the index had less to do with the company’s ESG rankings and more to do with Musk’s politics. The possibility of spiteful subjectivity is a significant challenge for ESG investing.

Doug Rongo, owner of Blue Ridge Wealth Services in Hickory, North Carolina, predicts that as time passes, more and more industries will be excluded from ESG lists. He believes that ESG-approved companies will be ‘government approved/government favored’ companies, not necessarily acting in the stockholders’ best interests.

Does ESG investment constitute greenwashing?

The current emphasis on ESG may offer public corporations paradoxical possibilities. The inclination to provide clients with what they desire may result in “greenwashing.”

Former Acting SEC Chair Allison Herren Lee stated a few months ago that “greenwashing,” or exaggerated or inaccurate claims about ESG practices, might mislead investors on investment assets’ underlying risks, benefits, and prices.

Yes, you should inquire whether a company’s “ESG” claims can be substantiated, but this is not the only inquiry you should pose. This situation can also occur with mutual funds but in a different way.

The more interesting question, Sievers explains, is whether the prospectus matches the actual holdings. Additionally, does a stock satisfy one measure but not another?

During a strong performance, nobody pays attention to matters such as greenwashing. When performance deteriorates, though, investors demand their pound of flesh. According to the Harvard Law School Forum on Corporate Governance, a substantial legal risk can result from greenwashing.

Should the SEC prohibit ESG-based mutual funds?

Therefore, why not simply avoid all of this? The SEC can do this by prohibiting the use of “ESG” and its derivatives in fund prospectuses and marketing materials.

The Feliciano School of Business’s Professor of Accounting & Finance, A. Seddik Meziani, whose ETF research includes an examination of ESG funds, says ESG-focused funds do not perform well in terms of ESG compliance. Still, we shouldn’t throw the baby out with the bathwater, and it would be excessive to outright prohibit them when the SEC could issue some rule suggestions creating a clear and robust framework for their usage.

This is precisely the objective of the SEC.

Banning ESG funds sounds excessive, but the SEC is rightly worried that the vague nature of ESG funds might mislead investors, explains Marcia S. Wagner of The Wagner Law Group in Boston. If a fund identifies as an ESG fund, it must specify what it considers and how it weighs each of these variables.

The fund’s prospectus might be required to contain highly detailed criteria or investing methodologies. For instance, the long-standing Ave Maria Fund declares that it is intended to avoid investments in enterprises perceived to sell products or services or participate in behaviors that are opposed to the essential values and teachings of the Roman Catholic Church.

The fund’s prospectus reads the Catholic Advisory Board establishes the screening criteria for enterprises based on religious beliefs. In making their conclusion, the members of the Catholic Advisory Board follow the teachings of the Roman Catholic Church. The Roman Catholic magisterium is the authority or office of the Roman Catholic Church to teach the accurate interpretation of God’s Word, whether in written form or universal faith and moral practices. This process will generally avoid four major categories of companies: 

  1. those involved in the practice of abortion
  2. those whose policies are deemed antifamily, such as pornographic material distributors
  3. those that contribute corporate funds to Planned Parenthood
  4. those that support embryonic stem cell research.

As previously stated, the Ave Maria equities funds have underperformed their benchmarks over the past decade; yet, for some investors, these moral considerations are worth the cost. Additionally, like many regional funds, the Ave Maria Fund’s prospectus does not use the terms “ESG” or “SRI.”

There may be other funds that can learn from this example.