Don't Be Fooled By Most ESG Rankings. Focus On Materiality Instead.

Are ESG investors being fooled?

The Wall Street Journal recently ran an article about how big technology stocks dominate ESG funds. Tech companies are not usually associated with the big ESG issues like climate change, renewable energy, or diversity. So, are investors being fooled?

Let’s consider whether the ESG investor is still concerned about investment performance. For most of the ones we talk to, the answer is yes. Big tech names dominate the market: Apple, Microsoft, Amazon, Facebook, and Alphabet are five of the largest companies in the S&P 500, so not holding big tech will impact your investment return versus the broad market. And ESG funds are (understandably) judged against how they perform versus the market as a whole.  

Given the reluctance to sacrifice investment performance for ESG, it is not surprising that ESG funds can, at first blush, look like any other fund. We need to dig deeper. Which tech names do they hold? And why did they hold them? Were tech companies selected just because they happen to be low carbon emitters? Is that how we think a tech company should be judged? Or did they score well on some ESG rating methodology with a few hundred inputs? Rather than adopt a one-size-fits-all approach, it pays to look at the small number of sustainability issues that have the biggest impact for that company. When it comes to measuring ESG impact, we think that materiality matters.

Not all ESG issues matter equally

The relevance of ESG issues varies industry to industry, company by company. For example, fuel efficiency has a bigger impact on both the carbon footprint and the bottom line of an airline than it does for an investment bank. If a bank says it has reduced fuel consumption by 50%, ESG investors should not hold their breath waiting for the bank’s share price to go up. If an airline makes the same claim, ESG investors should pay attention. Rather than looking at the same issues for every single company, we developed an ESG scoring methodology that is truly material to companies.

Why? We have found that traditional ESG scores are composed of a large number of issues that are not material for every industry or company, including large tech companies. Specifically, for two–thirds of all securities in the Russell Global Large Cap Index universe, less than 25% of the data items in the traditional score are considered material.

When we first launched our materiality score in 2017, we leveraged the ESG data from the data provider Sustainalytics alongside the industry–level materiality map developed by the Sustainability Accounting Standards Board (SASB). We found that this new combined score helped to serve as a keen ESG signal for investment decision–making. But even then, we knew we could make that score even better.

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