The data used to construct environmental, social and governance (ESG) portfolios differs widely among providers, meaning that funds may not be aligned with your clients’ objectives and beliefs. 

The trend toward investors incorporating ESG strategies into portfolios has been growing at a rapid pace. Morningstar reported that in 2019 estimated net inflows into ESG funds totaled more than $20 billion, a nearly fourfold increase from the prior year. According to the Global Sustainable Investment Alliance, ESG investing now accounts for more than $12 trillion – one out of every four dollars under professional management in the United States and one out of every two dollars in Europe.

One problem facing those who desire to incorporate ESG strategies is that the category is far from homogeneous, with the same stock often having very different ratings from the various providers of ESG scores. Jan-Carl Plagge and Douglas Grim, of the research team at Vanguard, highlighted this problem in their study, “Have Investors Paid a Performance Price? Examining the Behavior of ESG Equity Funds,” which appeared in the February 2020 issue of The Journal of Portfolio Management. Among their findings was that the return and risk of ESG funds can differ significantly and are driven by fund-specific criteria rather than by a homogeneous ESG factor. This finding led them to conclude that due to the wide dispersion of outcomes caused by systematic differences in portfolio holdings, investors are best served by assessing investment implications on a fund-by-fund basis. They added: “Our mixed and dispersed performance results suggest that it is difficult to make generalizations on the investment risk and return impact when replacing a conventional U.S. equity fund with an ESG fund. Carefully assessing the important and unique attributes of both funds seems to be an essential step in determining the potential direction and magnitude of any differences.”

The Research Affiliates study, “What a Difference an ESG Ratings Provider Makes!” examined the issue of the highly heterogeneous state of ESG investing. To provide investors with a better understanding of the ESG landscape, the authors, Feifei Li, and Ari Polychronopoulos reviewed ESG data providers. They then constructed ESG portfolios using different providers’ data to illustrate how the providers are incorporating their subjective judgments into the ratings, which leads to very different portfolio outcomes. Highlighting the problem, that they identified 70 different firms that provide ESG ratings data. And this didn’t even include the multitude of investment banks, government organizations, and research organizations that conduct ESG-related research that can be used to create customized ratings.

Li and Polychronopoulos broke the providers of ESG ratings into three broad categories:

1. Fundamental

Providers that collect and aggregate publicly available data (typically from company filings, company websites, and nongovernment organizations, or NGOs) and disseminate these data to end-users in a systematic way. Typically, these providers do not have a ratings methodology and do not provide overall company ESG scores. The user of the data must determine its materiality and develop their own methodology when constructing a portfolio.

2. Comprehensive

Providers that utilize a combination of objective and subjective data covering all ESG market segments. Typically, they develop their own ratings methodology and combine publicly available data as well as data produced by their own analysts through company interviews/questionnaires and independent analysis. These providers use hundreds of different metrics across ESG concerns and apply an established, systematic methodology to determine a company’s overall ESG score. In addition, they often scrub data from public websites and newspapers to supplement company ESG ratings with additional information, such as controversy assessments related to company-specific issues. They also produce country and industry trend reports.

3. Specialist

Providers that specialize in a specific ESG issue, such as environmental/carbon scores, corporate governance, human rights or gender diversity.

Following is a summary of their findings:

• Rating systems can vary dramatically, leading to very different ratings for the same company. These discrepancies are primarily driven by measurement (i.e., what metrics are used to assess different ESG attributes), differences in scope (i.e., what attributes are being assessed), and by weight (i.e., the level of materiality the ratings provider assigns to each attribute).

• Constructing portfolios from two well-known providers (Provider 1 covers roughly 1,900 U.S. companies and Provider 2 covers 2,100 U.S. companies, representing 97% and 99%, respectively, of U.S. market capitalization) and the period July 2010 through June 2018, they found an annual performance dispersion of 70 basis points (bps) a year in Europe (9.4% versus 8.7%) and 130 bps in the United States (14.2% versus 12.9%), which translates into a cumulative performance difference of 10.0% and 24.1%, respectively, over the full period – a notable difference for two strategies with an identical portfolio construction process. The tracking error between the two portfolios was approximately 1.5% in the United States and 2.2% in Europe, with an active share of 20% and 30%, respectively. Interestingly, both U.S. portfolios underperformed the simulated cap-weighted benchmark, and both Europe portfolios outperformed the simulated cap-weighted benchmark. The authors noted: “This is unsurprising given the short history, and we would caution against making any assertions as to the performance advantage of ESG investing or lack thereof.”

• There was an even greater performance dispersion in the portfolios constructed using individual ESG scores. The performance differences ranged from 70 bps a year to 220 bps a year, with the biggest dispersion and tracking error coming from the governance-based strategies in both geographic regions. Importantly, the correlation of the excess returns of the U.S. environmental, social, and governance portfolios were only 0.75, 0.51, and 0.50, respectively. The correlations of the excess returns of the Europe ESG portfolios were even lower at 0.68, 0.19, and 0.03. And the two governance portfolios in Europe had almost no relationship at all.

The important takeaway is that individual company ratings for ESG characteristics from the two different providers can be very different, and that leads to wide dispersions of outcomes. This led them to conclude that investors should select the provider whose ratings align more closely with their own views on ESG.

Each investor may have their own preferences about which ESG issues are important to address and how best to address them. Asset managers design portfolios with specific objectives in mind and those objectives might not correlate highly with your own. This creates real challenges given the large number and different types of providers, and the lack of correlation and consistency in ratings produced by them.