Sustainable Investing Works

Is sustainable investing a worthwhile approach to investing?

The grievances are legion lately: Perceived greenwashing in the fund industry is one. This week's salvo came from Aswath Damodaran, a well-regarded New York University finance professor, who, in a widely read blog post, denounced environmental, social, and governance investing as "a mistake that will cost companies and investors money, while making the world worse off."

I checked in with several Morningstar colleagues and other thoughtful sources about Damodaran’s piece. Their conclusion: Damodaran raises some good points, but he’s mostly wrong on his key assumption.

Damodaran asserts that sustainable investing is based on expectations that it can measure “goodness” in companies, despite widespread disagreement on ways to define and measure goodness. “Goodness is in the eyes of the beholder, and what you perceive to be a grievous corporate sin may not even register on my list, as a problem,” the NYU professor writes. It’s borne out, he says, by the fact that environmental, social, and governance ratings, or ESG ratings, can vary wildly depending on which ratings agency you look at.

Trouble is, most ESG isn’t about “goodness,” which is a strain of an older version of sustainable investing called “socially responsible investing.” Today’s version of sustainable investing is about measuring and managing financially material risk--and aligning values isn’t, in fact, the intent of most ESG investors.

ESG’s True Focus

“Good ESG metrics are an attempt to improve equity valuation and account for the risks posed to businesses from climate change and human resource regulations, are they not?” Sarah Newcomb, a behavioral economist at Morningstar, wrote on Damodaran’s Twitter feed. “I know you are more expert in equity evaluation than I am, but focusing on the squishy concept of 'goodness' avoids the more practical task of carefully measuring the cost of social and natural resource use, and including those costs in estimates of value,” Newcomb added.

Similarly, Jon Hale, head of sustainability research for the Americas at Morningstar, rejects the idea that sustainable investing is mainly about excluding investments such as tobacco or, in Damodaran's lexicon, "buying only good companies." Sustainable investing is much more: "It's about evaluating how a company handles its material risks and opportunities and assessing its broader impact on the world." Hale anticipated Damodaran's charges in this piece.

The wide range of ESG ratings, Hale says, represents a continuum that helps investors compare companies. Indeed, they’re a “proxy for the more qualitative, but abstract, concept of company sustainability that more investors today think of as important in developing a more complete understanding of a company. ESG ratings of a single company, therefore, should hardly be expected to always agree,” he writes.

It's a point to which Simon MacMahon, head of ESG and corporate governance research, Sustainalytics, returns repeatedly in an email exchange. ESG products and research are not simply focused on "doing good," says MacMahon: They aim to provide better, more comparable data and signals "to support the analysis of factors that previously were challenging for investors to analyze." For money managers, "incorporating material ESG considerations into investment decision-making is a fiduciary obligation."

MacMahon argues that ESG has resulted in a broad number of worthy initiatives, such as the European Union Action Plan on Sustainable Finance, the likely upcoming Securities & Exchange Commission regulations on mandatory climate disclosures, or lawsuits against, for example, Royal Dutch Shell RDS.A for greenwashing (Shell was recently found to be partially responsible for climate change and ordered to reduce emissions). “ESG, broadly speaking, is pushing in the right direction,” he says.

The World and the Wallet

Eventually, all this leads to addressing a key fiduciary obligation: Tackling the systemic risk that's perhaps the biggest risk for the financial markets. The largest is climate change. "The starting point for ESG is that value and risk are created in the real world, not the capital markets, and therefore you have to deal with real world sources of risk" that eventually affect the capital markets, says Jon Lukomnik, founder of Sinclair Capital, who once advised the New York City Pension Funds and is coauthor of Moving Beyond Modern Portfolio Theory: Investing That Matters.

Consider a service company trying to improve diversity practices. It isn’t simply “being good,” to borrow from Damodaran’s lexicon. Instead, “It’s measuring employee turnover and dealing with human capital risk” that eventually affects corporate valuation, Lukomnik says. “It’s a question of being risk-aware.” Such notions aren’t lost on executives coming up the management chain, who are personally interested in sustainability and aware that customers are interested in it, too.

An evolving sustainability ecosystem will continue to face criticism. It wasn’t so long ago that sustainable investing was a backwater in the investing landscape. That’s no longer the case: Investors are snapping up sustainable funds: In the second quarter, they set a new record of $8.4 billion. A further spurt of growth may lie ahead as the Biden administration takes a climate-friendly approach and, potentially, expands the ability of retirement plans to wade into sustainable investing.

The Road Ahead

Divergent ESG ratings should converge as disclosure improves and as investors gravitate toward particular ratings providers. Charges of poor returns are increasingly misguided: A Morningstar analysis found that, globally, there is no statistically significant evidence that investors needed to sacrifice returns when they invest in good ESG companies globally compared with bad ESG stocks.

Sustainable investing has many strands, and what's important depends on your particular preference. To help clarify what it means to you and how to best execute your plan, check out this accessible guide, "4 Steps to Add Sustainable Investing Strategies to Your Portfolio," by Morningstar's Alyssa Stankiewicz and Josh Charlson.

The hope is that many of these criticisms are resolved as ESG gets better, as disclosures improve, and adoption grows. Common standards will help. The Securities & Exchange Commission's new chief, Gary Gensler, has been pushing to expand ESG disclosures for asset managers and public companies. "We're still in the early innings," MacMahon says.