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The range of ESG funds, ratings and disclosures requires investors and advisors to take a careful look at opportunities.grapestock

When an ESG designation for a fund can mean everything, does it mean anything?

It can be challenging to define investments that reflect exemplary performance in environmental, social and governance practices. The rose-coloured glasses are coming off. Many investors are becoming increasingly concerned about how securities are rated, the lack of regulatory standards, and the ability of companies to execute on their ESG commitments.

It’s more important than ever to “look under the hood to determine which funds are aligned with your values and performance expectations,” says Amr Addas, an adjunct finance professor and a senior advisor for sustainability at Concordia University in Montreal.

Even that isn’t easy to do. Mr. Addas says ESG lumps together three broad elements that often conflict with each other. “I can’t think of a single investment that’s aligned with all three issues – the E, S and G.”

With the broad range of factors ESG encompasses, it’s possible to categorize nearly any company as adhering to some sort of ESG values.

Another complication is that the landscape is dotted with several major indices and dozens of custom indices, offered by companies such as MSCI, Sustainalytics, Refinitiv, S&P Global, Bloomberg and FTSE Russell. Each have different scoring methodologies, and there’s no standard for screening companies for inclusion in ESG funds or indices, and no uniformity in what’s deemed to be an ESG fund.

ESG rating criteria also involve a degree of subjectivity, especially in the absence of credible public company data. That makes investors reliant on voluntary disclosures, or forced disclosures through shareholder activism.

To make matters more complex, ESG rating criteria are often conflicting. A company might have a passing grade in some of its activities and a failing grade in others. So its ratings can land anywhere, or a company could be outright excluded from certain indices.

Research from the MIT Sloan Sustainable Initiative found that ESG data is “noisy,” meaning the independent agencies that evaluate and assign ESG ratings to firms often diverge. They say this “leads to a much lower probability that ESG ratings have a direct correlation to financial performance, undermining their utility as an investment tool.”

Given these inconsistencies, Mr. Addas expects ESG investing to come under greater scrutiny as it becomes even more mainstream. He suggests the need for “standardizing sustainability reporting across countries and geographies.”

In the absence of defined standards, each ESG fund makes its own rules. Earlier this year, the Canadian Securities Administrators (CSA) issued guidelines that call for the following:

  • Alignment between the name of funds and their investment objectives.
  • Disclosure of investment strategies used to achieve objectives.
  • Explanations of how ESG factors are evaluated and monitored.

Canada’s guidelines fall short of the more stringent European and U.S. guidelines, Mr. Addas says. In the United States, the Securities and Exchange Commission has released proposals that would require companies to allow for comparability across some funds, and disclose what ESG impacts they seek to achieve and the metrics they use to assess progress.

In the European Union, investment managers and financial advisers are compelled to act on the “sustainability preferences” of retail clients. Investors can also hold asset managers accountable if their ESG funds aren’t as advertised, although enforcement is questionable.

Despite the concerns about ESG, many investors continue to flock to these funds. According to Morningstar Canada, assets under management of ESG investment funds rose to $31.5-billion at the end of the second quarter of 2022, up by 15 per cent year-over-year.

“What we have witnessed is that ESG mandates have generated similar risk and return characteristics to their non-ESG counterparts,” says Rob Duncan, senior vice president, portfolio manager and chief ESG officer at Forstrong Global Asset Management Inc., in Toronto. “An argument can be made that performance across ESG and non-ESG mandates are broadly converging.”

Mr. Duncan doesn’t feel that the ESG label has become meaningless through overuse. “In fact, the reverse is true; there are too many meanings, as ESG can mean something different to every type of investor.”