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Stocks Rout Poses a $30 Trillion Ethical Test

Clara Ferreira Marques

(Bloomberg Opinion) -- What happens to environmental, social and governance-oriented investment in a market shock? We’re about to find out. Socially responsible investing, which has become a feature of the financial landscape and a $30 trillion-plus industry, came of age long after the last major financial crisis. Expect a welcome dose of scrutiny.

So far, it hasn’t been pretty. By early Thursday, the Bloomberg SASB US Large Cap ESG Index had dropped almost 21% from a peak Feb. 19, a steeper fall than the S&P 500 Index. The MSCI World ESG Leaders Index dropped almost 19%, roughly in line with the broader MSCI World. The heftiest ESG funds by and large did better, though only narrowly.  

This isn’t a huge surprise: Many such funds track the benchmark, and then tilt toward more ESG-friendly companies. They are unlikely to react in a dramatically different way to a widespread market shock, especially one that batters both supply and demand. That’s true for all but the most active managers, and probably only if they have shied away from polluters including big drillers, airlines, cruise companies and the like, all of which have been badly hit by the coronavirus and the subsequent oil crash. 

It does, though, raise an uncomfortable question. What happens to ESG when doing good isn’t — at least momentarily — the same as doing well?

ESG investing has leaned heavily on the credible premise that companies scoring well on factors such as diversity, health and safety, and managing carbon risk will do better than peers. Who cares wins, in the words of the United Nations Global Compact. It’s a sensible idea well-supported by research. Yet ESG is untested in times of extreme stress, when short-term market ructions will strain market participants, however lofty their longer-term objectives. We simply don’t know how investors and fund managers will behave, or how firms will act when really squeezed.

What’s at stake isn’t ESG performance per se. It’s a long-term investment philosophy that focuses on backing companies that are, by virtue of how they are run and what they produce, more resilient to climate, social and other change. How a fund performs in a bad patch probably doesn’t say much about the multi-decade resilience ESG is supposed to promote. Conversely, a capital exodus that has seen tens of billions wiped off the value of energy companies, and especially the U.S. shale industry, isn’t a clear win for ESG.

Yet for investors, today’s market problems can dwarf tomorrow’s green ones, especially if the virus and oil crunch turns into financial cataclysm.

For now, there are reasons to take heart. First, investors are proving pretty sticky when it comes to ESG, at least for now. A Bloomberg Intelligence analysis of ESG exchange-traded funds during the last week of February found that only 8% of U.S. ESG ETFs saw outflows, against almost a quarter of all ETFs. European-listed ESG ETFs saw inflows. That matches research from Morningstar last year, which suggested that in a lackluster 2018, the decline in new money into European-domiciled ESG funds was smaller than for the wider European fund universe — 40% against almost 80%.

Second, and more significantly, all this upheaval will accelerate a trend toward examining ESG claims far more closely, and pushing for greater transparency. For an investment principle that has been nebulous, thriving in a proliferation of reporting and scoring standards, this is overdue. 

Greenwashing, where misleading descriptions create an exaggerated image of environmental responsibility, should become harder if investors ask probing questions. For example, one of the reasons for the sharp drop in funds and indexes has been the slump in oil company shares. Should broad ESG funds hold oil? Is a low-carbon option, which is underweight energy, better than a fossil-free one? What about airlines, and car manufacturers, also badly hit in the recent decline? 

There are plenty of arguments on both sides: The need to support those shifting toward energy transition would suggest selective inclusion of better-performing drillers or auto giants, while excluding them means more volatility. Either way, funds will have to prepare good answers, or shed an ill-deserved ESG mantle.

Transparency is also an excellent way of dealing with the risk of ESG mis-selling, a threat that has grown along with the industry. Britain’s Financial Conduct Authority already said last year it would take action against those claiming unfairly to be green.

Third-party data specialists, providing ratings which can be inconsistent and rely heavily on subjective, retrospective inputs, will get more questions, too. 

Those are a few (green) reasons to cheer in the gloom.

To contact the author of this story: Clara Ferreira Marques at cferreirama@bloomberg.net

To contact the editor responsible for this story: Matthew Brooker at mbrooker1@bloomberg.net

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Clara Ferreira Marques is a Bloomberg Opinion columnist covering commodities and environmental, social and governance issues. Previously, she was an associate editor for Reuters Breakingviews, and editor and correspondent for Reuters in Singapore, India, the U.K., Italy and Russia.

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