As demand for ESG breaks new records every quarter, concerns about greenwashing — when companies claim to have environmental impact they can’t back up — may overtake concerns about financial performance as the primary inhibitor to the growth of sustainable investing (according to one survey, it already has).
The SEC has taken notice of the danger that greenwashing poses to investors. In April, the regulator warned financial advisors and fund managers to protect investors from being misled after finding contradictions between fund managers’ ESG marketing and public policies, and their actual practices. The agency even prescribed the correct solution to combat greenwashing: perform diligence on a fund manager to make sure it actually follows its stated ESG frameworks, negative screens, ESG ratings, and proxy voting/shareholder engagement policies.
Investors and the SEC are right to be concerned. Greenwashing redirects capital toward less impactful investments and prevents people from truly aligning their portfolio with their values.
But despite increasing attention, greenwashing persists and wealth managers need to recognize the part they are playing in the problem.
Why Advisors Have a Hard Time Avoiding Greenwashing
ESG due diligence takes more time than many advisors have, and the shortcuts are fool’s gold.
Some advisors identify obvious red flags — like mining companies in the top holdings of a fund. While this process might satisfy some clients interested in negative screening, it is not sufficient to identify greenwashing. For example, a mining company might receive a high ESG score relative to peers, then a fund manager employing a best-in-class ESG approach seeking industry leaders might knowingly or inadvertently include the mining company in an ESG fund.
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Unfortunately, advisors can’t rely on third-party ESG ratings to solve the problem. As the 2020 paper Aggregate Confusion makes clear, ESG ratings often contradict each other. Since there’s no single definition of ESG, an advisor that disagrees with a fund’s holdings can’t possibly know if a fund is actually applying ESG criteria, or if its ESG strategy is just marketing fluff. ESG ratings’ one-size-fits-all approaches don’t accurately cover the wide range of ESG strategies. For example, a renewable-energy focused fund explicitly focused on positively impacting climate should not be considered a “poor ESG” investment if it has low gender diversity. Likewise, a gender or racial diversity fund should not be dinged for having less exposure to renewable energy companies.
Advisors also need to be wary of funds with a good holdings-based ESG rating but no stated ESG strategy. As the holdings change over time, the ESG score could also change.
Perhaps most important: ESG ratings don’t currently look at shareholder engagement and proxy voting. Engine No. 1’s new Transform 500 ETF (ticker: VOTE) might get an average ESG score by some measures for tracking the S&P 500. But it could certainly have an impact through its ESG proxy voting strategy, making it hard to call it greenwashing. The investment firm has already won seats on ExxonMobil’s board.
With all this nuance in mind, advisors are turning to their trusty research tools to help them find funds with good scores and a dedicated ESG strategy. But those also have pitfalls.
Fund screener research tools — that aim to provide a list of sustainable funds based on strategy, not just a point-in-time ESG rating — are gatekeepers. These research providers are designed to be objective, so as not to inject their own analyst opinions, which means they must set some basic standards for funds to qualify as ESG. The least common denominator is looking for funds that mention ESG in their prospectus language — that’s often what’s used as the ticket to the ESG party.
Defining a sustainable starting universe based on word-matching invites greenwashing out the wazoo.
We could create a fund and call it the “Save the Planet ESG Fund,” underweight an oil and gas company for ESG reasons described in the prospectus, and get in front of eyeballs looking for something in a sustainable fund universe. And if we were backed by a large fund family with a recognizable name, and charged low fees, we’d probably get inflows.
What Advisors Need to Do
Advisors can take two easy steps to combat greenwashing.
First, they must evaluate a fund’s holdings to make sure the fund is following its own ESG policies. A “Fossil Fuel Free” fund should not invest in fossil fuel companies. A “Gender Diversity” fund should probably not invest in any companies that have no women on their boards of directors (unless they have an explicit activist strategy to change that company).
Second, advisors must evaluate a fund’s ESG strategy.
Many advisors already have the right idea and draw from the sustainability universe — they know to evaluate a fund’s strategy and commitment to ESG in addition to its point-in-time ESG score. However, the appearance of “ESG” or “sustainable” in a prospectus does not indicate a devotion of significant resources towards a robust ESG strategy. See where your fund manager falls on this list of asset managers ranked by their support of climate-related proxies, or this ranking of asset managers’ approaches to responsible investment, or check out the methodology that we developed to assess the real impact of fund manager activities.
We’d argue that the most important work of a financial advisor is determining if a fund’s strategy matches their client’s values. A client that campaigns against tobacco companies might not want to invest in any tobacco companies regardless of how high its ESG rating is, or the impact on tracking error of excluding that company.
Other clients may be more interested in capturing the value that will come from the massive energy transition by overweighting renewable energy companies. Others still might not care about climate change, but want to invest in the companies with the best gender and racial diversity, while excluding companies with zero women on their boards.
To provide the best ESG service, advisors should develop robust processes to survey clients on the ESG values that matter most to them. But they must also offer a range of ESG solutions to best fit clients’ specific values and ESG goals.
Gabe Rissman is the president and co-founder of YourStake, a tools, data, and reporting metrics platform that financial advisors and asset managers use to evaluate ESG investments.
Cary Krosinsky teaches sustainable finance at Brown University and Yale University. He has authored and edited books and papers on sustainable investing, including his recent third book, “Sustainable Investing: Revolutions in Theory and Practice.” He is also co-founder and director of the Carbon Tracker Initiative and Real Impact Tracker.