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  • Writer's pictureAlexander Hill

Is Socially Responsible Investing Achievable for Passive Investors?

Updated: Jul 6, 2022

Author Note

There may be some conflict of interest, as the author is a passive investor. However, the author acknowledges they may have bias but aim to write from an objective perspective. This report follows 7th edition APA referencing and formatting.


Key Terms: Exchange-traded funds (ETFs), ESG (Environmental, Social and Governance [sustainability]), MSCI, Index


The Data

Recently, I have been researching socially responsible (SRI/ESG) exchange-traded funds (ETFs) intending to create a portfolio of SRI/ESG ETFs. There are many different types of socially responsible ETFs, although I am yet to find an ETF with an altruistic investment objective. Retrospectively, it was naïve to expect any funds to have altruistic investment objectives when competing in a capitalist market. However, there has been a surge in socially responsible investing over recent years. A recent survey found 72% of 18-34-year-olds want to know whether a company aligns with their social and moral beliefs before investing in stock (Wealth Adviser, 2021). With a growing interest in socially responsible investing, I expected some funds to represent the demand. This assumes that individuals interested in socially responsible investing have altruistic intentions for a sustainable global economy. However, the investment objective of most SRI ETFs is to invest in socially responsible companies because they are considered more profitable. Investing for profit results in ETFs investing in companies that vary in ESG (Environmental, Social and Governance [sustainability]). Popular stocks such as Tesla are heavily weighted in most SRI ETFs, despite being rated as average for ESG by MSCI (MSCI, 2021b).


MSCI produce ESG ratings for thousands of big companies and investment funds. MSCI give ratings from AAA to CCC, with AAA described as an industry leader (see Figure 1). AXA SA is rated AAA despite being a laggard for corporate behaviour (see Figure 2). This likely factors in AXA’s investments in four major Israeli banks that play a significant role in the Israel-Palestine conflict, or rather the Israeli oppression of Palestinian’s (BDS Movement, 2021). Despite this failure of ESG for corporate governance, AXA SA receives the highest ESG rating. This suggests there are significant flaws in MSCI’s ESG methodology for socially responsible investors. Similarly, Puma SE is rated AAA and has Israeli involvement, sponsoring the Israel Football Association which includes teams located on Palestinian territory (BDS Movement, 2021). Whilst Puma’s involvement may not be as direct or severe as that of AXA, it appears to have little/no bearing on MSCI’s judgement as they score as an ESG leader for corporate behaviour (see Figure 3).


Figures 1 MSCI Rating Descriptions

Note. Descriptions of what ESG rating mean. From ESG Ratings, by MSCI, 2021 (https://www.msci.com/our-solutions/esg-investing/esg-ratings). In the public domain.


Figure 2

AXA SA Key Issues

Note. Overview of key issues used to assess ESG rating for AXA SE. Taken from ESG Ratings Corporate Search Tool, by MSCI, 2021 (https://www.msci.com/our-solutions/esg-investing/esg-ratings/esg-ratings-corporate-search-tool/issuer/axa-sa/IID000000002123746). In the public domain.


Figure 3

Puma SE Key Issues

Note. Overview key issues used to assess to ESG rating for PUMA SE. Taken from ESG Ratings Corporate Search Tool, by MSCI, 2021 (https://www.msci.com/our-solutions/esg-investing/esg-ratings/esg-ratings-corporate-search-tool/issuer/puma-se/IID000000002140428). In the public domain.


An MCSI rating of ‘CCC’ is described as an industry laggard (see Figure 1). As implied, a company's ESG rating is created in comparison to other companies in its industry. Therefore, it would be logical for ESG ratings to be normally distributed within an industry, especially as the middle category is defined as ‘average’. The ‘retail - consumer discretionary industry’ is normally distributed (see Figure 4). However, the ‘semiconductors and semiconductor equipment industry’ shows a positive skew (see Figure 5) and the ‘software and services industry’ shows a negative skew (see Figure 6). With 43% of companies rated industry leaders and only 13% of companies below the median rating ‘BBB’, the distribution of the ‘professional services industry’ is irrational (see Figure 7). The lack of consistency in distributions across industries is a fundamental limitation of the MSCI ESG methodology. Moreover, the industry-based methodology leads to some stocks in controversial industries rated as ‘ESG Leaders’. For example, 20% of stocks in the ‘integrated gas and oil industry’ are rated as leaders (see Figure 8). Whilst the MSCI website consistently states that a company’s ESG rating is industry-specific, it can be misleading when sourced from other places. This is particularly apparent for ETF ESG ratings.


Figure 4

Distribution of ESG Ratings within the Retail - Consumer Discretionary Industry

Note. Taken from ESG Ratings Corporate Search Tool, by MSCI, 2021 (https://www.msci.com/our-solutions/esg-investing/esg-ratings/esg-ratings-corporate-search-tool/issuer/best-buy-co-inc/IID000000002159525). In the public domain.


Figure 5

Distribution of ESG Ratings within the Semiconductors & Semiconductor Equipment Industry


Figure 6 Distribution of ESG Ratings within the Software & Services Industry


Figure 7 Distribution of ESG Ratings within the Professional Services Industry

Note. Taken from ESG Ratings Corporate Search Tool, by MSCI, 2021 (https://www.msci.com/our-solutions/esg-investing/esg-ratings/esg-ratings-corporate-search-tool/issuer/relx-plc/IID000000002145455). In the public domain.


Figure 8 Distribution of Ratings within the Integrated Oil & Gas Industry

Note. Taken from ESG Ratings Corporate Search Tool, by MSCI, 2021 (https://www.msci.com/our-solutions/esg-investing/esg-ratings/esg-ratings-corporate-search-tool/issuer/bp-plc/IID000000002140371). In the public domain.

The MSCI's ETF ESG methodology is transparent, although it could be difficult for passive investors to interpret. The MSCI provide environmental and social data for funds on its search tool but do not use it in its methodology. An ETF ESG score is produced from a weighted average of the ESG scores of the fund’s stocks (MSCI, 2021a). However, that value is then multiplied by a percentage which appears to be derived from whether stocks are positively or negatively ‘trending’. This multiplier may be attributing too much focus to the future projection of companies within the fund, which may already be questionably rated due to the MSCI stock methodology. The iShares UK Dividend ETF is considered an ESG leader, rated AA (iShares, 2021c). It is in the top 3% of all ETFs for ESG. However, the MSCI data suggests it is not very socially responsible. The ETF is ranked moderate for carbon intensity, with 64% of the total revenue generated from fossil fuel-based revenues. The corporate Governance statistics are good compared to other ETFs; however, some companies in the fund fail social safeguard screens. 6% of the fund violates the United Nations Global Compact (UNGC) principles and face very severe controversies in accordance with the guidelines of the Organisation for Economic Co-operation and Development (OECD). Despite this, only 2% of the fund's investment has a rating below BBB (see Figure 9). Furthermore, the distribution of the iShares UK Dividend UCITS ETFs individual stock ESG ratings show the median rating of the ETF is A. The iShares UK Dividend UCITS ETF currently has Imperial Brands, British Tobacco and BP in their top 4 investments (iShares, 2021c). The latter has historically been in the oil and gas industry, whilst the two formers are Tobacco companies. Individually, Imperial Brands is rated A, whereas British Tobacco and BP are rated BBB. Given the recent history of these companies, ratings of average and above are arguably generous. This suggests that the momentum multiplier is exacerbating weaknesses in the stock ESG methodology which overrates companies who have committed to improving their poor ESG performance, producing a positive trend. Another example of the disparity between an ETFs rating and the ESG distribution of its stocks is Vanguard FTSE 100 UCITS ETF (Vanguard, 2021). The ETF is rated AAA; however, only 16% of the fund is invested in AAA-rated stocks. The median value of the stock distribution is at the lower end of AA (see Figure 10). Furthermore, 7.8% of the fund violates both UNGC principles and OECD guidelines. The ETF scores moderate for carbon intensity, with 80% of revenue coming from fossil fuel-based revenues. Thus, the AAA ratings for both Vanguard FTSE 100 UCITS ETF and iShares UK Dividend ETF are illogical based on the data provided. This suggests that the methodology is not fit for private investors seeking socially responsible investments because ETF ESG ratings are not representative of socially responsible actions.


Figure 9 ESG Rating Distribution of iShares UK Dividend ETF Holdings


Figure 10

ESG Rating Distribution of Vanguard FTSE 100 UCITS ETF Holdings


Most SRI/ESG ETFs invest in stocks from indexes created by the MSCI. For example, the iShares MSCI World SRI UCITS ETF invests in stocks on the MSCI World SRI Select Reduced Fossil Fuel Index (iShares, 2021b; MSCI, 2021e). ETFs will benchmark their investments to the index. The MSCI creates indexes with set criteria. Having assessed multiple ETFs using the predominant SRI/ESG MSCI Indexes, the most socially responsible global index is the MSCI World SRI Select Reduced Fossil Fuel Index. The MSCI World ESG Enhanced Focus Index appears to be the next best global option (MSCI, 2021c). The MSCI World ESG Screened Index fairs the worst as a global sustainable index (MSCI, 2021d). The inferred reason for these indexes is for investors to avoid unsustainable companies because they are a risk to the individual’s capital. Ultimately, all three indexes are very poor at being socially responsible. The largest constituent of two MSCI ESG indexes is Apple, which is rated BBB. The second-largest constituent of the MSCI World SRI Select Reduced Fossil Fuel Index is Tesla, which is given an average ESG rating of A. Tesla is a leader for 3 key issues, average for 1 key issue and laggard for 2 key issues. One of the key issues Tesla is laggard in is Labour Management. It is well documented that Tesla is accused of violating workers’ rights, such as threats against worker unionisation and coercing workers into signing away the right to discuss working conditions and safety concerns (Perrone, 2020). Yet, Tesla heavily features in all MSCI indexes (MSCI, 2021c; MSCI, 2021d; MSCI, 2021e). Therefore, ETFs that benchmark an MSCI SRI/ESG Index are potentially misleading passive investors into believing they are participating in true socially responsible investing. Furthermore, there are doubts about the independence of the MSCI after it included Chinese A-shares (domestic mainland companies) in the MSCI Emerging Markets Index (MSCI, 2018). The MSCI is speculated to have succumbed to pressure from the Chinese Government after attempts to hinder the company’s business in China (Bird, 2019). Therefore, the overall legitimacy of the MSCI and its indexes is questionable.


It is important to mention that other institutions assess the sustainability of stocks and funds, such as Bloomberg and Russell. Neither institution shares its ESG data publicly with private investors. However, Morningstar provides accessible ETF ESG data for private investors on its website (Morningstar, 2021). The Morningstar uses ESG risk data for specific stocks from Sustainalytics to create their ETF ESG risk scores (Sustainalytics, 2021). The Morningstar ETF methodology is similar to MSCI, as they calculate the weighted average. However, Morningstar's ETF methodology emphasizes past scores, which is a significant strength when compared to the MSCI ETF methodology. Morningstar factor in ETF portfolio scores for up to 12 months prior (Morningstar, 2019). Consequently, both iShares UK Dividend UCITS ETF and Vanguard FTSE 100 UCITS ETF score higher for ESG risk than most SRI/ESG ETFs (see Figure 11). One exception is the iShares Emerging Markets SRI ETF, which has significant Chinese investment (iShares, 2021a). Real estate ETFs ESG risk scores are better than most ETFs (see Figure 11). Thus, Sustainalytics’ ESG risk methodology appears to undervalue the ESG impact of real estate stocks. Real estate companies have contributed to rising housing prices, which is pricing young adults out of homeownership and contributing to a growing generational wealth gap (Wallach, 2020). Real estate companies often pose environmental risks by building on green sites, although this is now heavily regulated. Despite apparent ESG issues in the real estate industry, they may not be recognised in Sustainalytics’ ESG risk methodology. Therefore, the MCSI’s industry-based methodology may be a more accurate source of ESG data for stocks in the real estate industry.


Figure 11

The Morningstar ESG Scores and MSCI ESG Ratings of a Selection of ETFs

Note. The data for Morningstar ESG Risk Scores are taken from Morningstar Home, by Morningstar, 2021 (https://www.morningstar.com/). Copyright 2021 by Morningstar, Inc. The data for MSCI ESG Ratings are taken from ESG Fund Ratings, by MSCI, 2021 (https://www.msci.com/our-solutions/esg-investing/esg-fund-ratings). Copyright 2021 by MSCI, Inc. Data correct as of 04/07/2021.


Morningstar’s (Sustainalytics’) overall ESG risk score is logical, meaning private investors can easily understand it. The three pillars of ESG each have an individual score which adds up to an overall ESG score (Morningstar, 2019). However, there was a website problem with Morningstar as individual ESG scores did not add up to the overall score, which was often significantly higher. There was no explanation or logical reason for these scores to be different, suggesting they were mistakes. These inaccuracies appear to have been corrected, although there are still differences with some ETFs. Therefore, the data presented by the Morningstar website is unreliable, however, Morningstar’s ESG data is arguably better suited for passive investors than MSCI ESG data.


There is one major limitation of all the ESG methodologies presented - quantitively measuring companies for sustainability is inherently problematic. The matter of assessing the sustainability of a company is case-specific, and potentially highly subjective. Most companies operate differently from each other, even within industries. Institutions such as the MSCI categorise ESG issues to be quantitatively measured. This leads to the problem of weighting the influence of each issue towards a quantitative score, which is highlighted by AXA’s AAA rating. The generalised nature of using a standardised, quantitative measure is simply an unreliable approach to accurately assessing a large group of companies for ESG. Instead, an in-depth qualitative approach should be used for both reliability and validity reasons. However, qualitative data is not efficient at providing evidence for trading decisions on thousands of companies. Furthermore, research suggests that 31% of investors trust ESG data more when it is quantitative, which is counterintuitive as quantitative data lacks reason and explanation (Wealth Adviser, 2021). As stated, most institutions only provide detailed ESG data to institutional investors, charging thousands of pounds for the privilege. Methodologies should be transparent to provide access to individuals to decide if the methodology aligns with their ESG values.


The ESG world is dynamic and ever-changing. A good example is the recent news of senior executives of Iberdrola SA, the second-largest publicly listed company in Spain, being named as suspects in a criminal investigation (Dombey, 2021). The MSCI is yet to change Iberdrola’s average categorisation of either corporate governance or corporate behaviour as key issues. Additionally, the MSCI currently give Iberdrola SA an AAA rating. This indicates another issue of ESG data is that it will always be playing catch up. This is particularly an issue if an ETF is to have the objective of being socially responsible because they are passively managed, with reconsiderations often occurring on a semi-annual basis. Therefore, if true socially responsible investing is to be accessible to passive investors, it is likely to be in the form of an actively managed fund (mutual fund). However, the only functional difference between current SRI/ESG ETFs and SRI/ESG mutual funds is that the latter are actively managed.



The Psychology

MSCI Data

The MSCI use a scoring scale of AAA-CCC (see Figure 1). Traditionally, individuals in western cultures often leave education associating an ‘A’ grade (rating) as excellent, a ‘B’ grade as above average and a ‘C’ grade as average. Whilst it is common for non-academic institutions to use the letter C as a negative rating (see Figure 1), it could be argued that a CCC rating would not provoke a negative psychological association. This is significant when considering the motives of the MSCI, who rely on other institutions to pay for their services.


Alternatively, the MSCI present the scoring scale with a green-yellow-red colour continuum on their website (see Figures 1-10). Research into colour association suggests that when used in context, colours have meaning (Elliot & Pazda, 2012). The colour green is commonly associated with success, whereas the colour red is associated with failure (Moller et al., 2009). Thus, previous research would suggest that associating ESG ratings with a green-yellow-red colour continuum would provoke individuals to associate stocks with ESG failure or success. However, when institutions state the sustainability rating for one of their ETFs, the colour associated with the rating is not presented. Therefore, passive investors will only make associations with the letter rating unless their research takes them to the MSCI website.



Investor Behaviour

Private investors may trust the institutions involved to invest in socially responsible companies because they believe the institutions are in a better position to make such judgements. The Dunning-Kruger effect suggests that more intelligent individuals often underestimate their knowledge (Kruger & Dunning, 1999). Therefore, intelligent individuals may be susceptible to overestimating the abilities of others because they assume large institutions would be more knowledgeable. Alternatively, intelligent individuals may be susceptible to the curse of knowledge; individuals overestimate others’ knowledge due to ego-centric perspective-taking, assuming others have similar intellect. Such individuals may expect institutions to have a similar judgement, if not better as they have increased access to resources. Research suggests 62% of investors find it difficult to judge the sustainability of companies (Wealth Adviser, 2021).


Some individuals may not have time to investigate ETFs for socially responsible investments and subsequently invest in an SRI/ESG ETF with little research. When doing research, individuals may fall to confirmation bias if they see an SRI/ESG ETF invests in some stocks they consider socially responsible and assume the others are too. The Dunning-Kruger effect and the better-than-average effect could be used to suggest that less intelligent individuals would be more likely to fall for confirmation bias if their overestimated judgement is reaffirmed (Gignac & Zajenkowski, 2020). However, some research suggests cognitive biases are half as influential amongst individuals when making market decisions compared to non-economic judgements (Camerer et al., 1989). This research was conducted using active market traders, so it is not necessarily indicative of passive investor behaviour.



Conclusions

I believe the recent surge in socially responsible investing is largely investors with altruistic intentions. However, institutions involved in socially responsible investing (SRI/ESG ETFs) have the investment objective of profiting from a global shift to a sustainable economy, avoiding unsustainable stocks because they’re viewed as a risk to capital. Therefore, I think there is a significant disconnect between the motives of passive investors interested in socially responsible investments and the socially responsible investments available. Transparent data regarding socially responsible investing is not available to passive investors, and current socially responsible investment funds are somewhat misleading. Furthermore, subtle psychological biases present in the ESG investment world could mislead the new wave of passive investors into investment decisions that do not truly reflect their altruistic intentions.


For passive investors to draw accurate conclusions from sustainability data, they would have to conduct thorough research and understand the inherent flaws of using quantitative data for measuring companies’ sustainability. Whilst it may sound silly for institutions to offer investments that sacrifice profitability for moral beliefs, I believe institutions could further compromise the performance of socially responsible funds for greater morality.


Currently, socially responsible investing is a fallacy sold to passive investors.




Notes

This report was written between June 20th and July 14th; therefore, the secondary data used may have changed.



Further comments

See this thread for further details regarding issues of ESG data: https://twitter.com/jeuasommenulle/status/1408415114034921473?s=20

Thanks to Chiara Marci for helping with the editing process.



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