Research by French think-tank Edhec shows that ETFs that are so-called “Paris aligned” take the climate score into account for no more than 12% of the factors underlying stock selection. Climate scores, at best, play second fiddle.
“We see that although many asset managers boast of their contribution to the “net zero” goals of the Paris Climate Agreement, the use of climate data in portfolio construction is, on average, zero,” said Felix Goltz, principal researcher at Edhec, in an interview with Fondsnieuws, Investment Officer Luxembourg’s sister publication. The leading investment solutions think tank for private and institutional investors, which belongs to the business school of the same name, published the critical report Doing Good or Feeling Good? Detecting Greenwashing in Climate Investing (see attachment).
Portfolio Greenwashing
Edhec investigated ETFs registered in Europe of renowned fund houses, which in their names and positioning claim to be focused on “low carbon”, “climate change” and “Paris-aligned” indices. Edhec has stated that it is shocked by the results of the research. The first, most discussed and criticised form, is the so-called “corporate greenwashing”, according to Edhec. This involves underlying companies advertising the environmental performance of their products in a way that is substantially inflated or even contradicts reality.
In addition, said Goltz, there is “portfolio greenwashing”. “Fund managers claim that their funds have a positive impact on the environment, when in fact they are not managed in a way that is consistent with promoting such an impact.”
According to Goltz, regression analysis, a statistical technique used to establish consistency, shows that the weight of individual titles is mainly determined by market capitalisation. Remarkably, that factor determines as much as 88 per cent of the differences in the weight of stocks in sustainable ETF portfolios. “So a rapid deterioration in a company’s sustainability score can be more than compensated for by an increase in market share, and we see that happening a lot,” says Goltz.
A very counterintuitive development, according to Goltz, is the fact that as many as 35% of companies with deteriorating ESG scores were actually “rewarded” with larger positions in the chosen index, according to the research. For companies that specifically underperformed in the area of carbon emissions, the percentage rises to 41 per cent. “There is no statistically demonstrable relationship between positive changes in carbon intensity and the weight in the composite portfolio,” said Goltz.
Even in strategies with mixed objectives, market capitalisation remains the main driver, at 73 per cent on average, followed by the ESG score, at 21 per cent on average. This means that only 6 percent remains for the (weighting of the) climate score. The indices studied are from index providers such as MSCI, FTSE, Russell and S&P Dow Jones, all of which claim to support the fight against climate change. At the same time, the names of Amundi, BNP Paribas, HSBC and DWS feature in the research.
Indices focus too much on market share
While investors pursue climate targets to decarbonise investment portfolios, the real impact of decarbonising portfolios in practice remains unclear. Achieving “impact” at the portfolio level is attractive for product marketing, but it is not guaranteed to translate into significant effects in practice, Edhec wrote in its research report.
According to Goltz, part of the problem lies in the dominance of benchmarks as a starting point. “Asset managers link their portfolios to these indices and then do not deviate too much from them. The active component on their side is negligible. Because indices focus strongly on the market share of individual shares, most funds do the same and climate considerations are of minor importance. There is a lack of common sense here, both on the part of the index builder and the investor.”
“Investors spend a tremendous amount of time trying to figure out the performance and financial risks of funds and stocks,” he said. “The industry needs to spend that time, if not more, evaluating the consistency of impact funds’ investment strategy. A stock selection strategy that is not 50 per cent explicitly based on climate criteria is thus based on something else.”
According to Goltz, investors should therefore focus much less on the impact of strategies and much more on consistency in stock selection. “Growth and momentum strategies were never intended to make sustainability impacts. The standard practice of portfolio construction is incompatible with the goal of making an impact.”
The assets of funds claiming to be “sustainable” increased to $2,300 billion from 2018 to mid-2021, Morningstar data shows. Funds that focus specifically on clean energy, climate solutions and carbon reduction have increased their inflow by a factor of 9 to $270 billion in the same period.