Learn To Invest
Stocks Special Reports LICs Credit Funds ETFs Tools SMSFs
Video Archive Article Archive
News Stocks Special Reports Funds ETFs Features SMSFs Learn


Sustainable investing is about managing risk, not “goodness”

Leslie Norton  |  21 Sep 2021Text size  Decrease  Increase  |  
Email to Friend

OPINION/ Is sustainable investing a legitimate style of 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 (ESG) investing as “a mistake that will cost companies and investors money, while making the world worse off.” 

I spoke 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 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 risk, and aligning values isn’t, in fact, the intent of most ESG investors. 

“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.

Investing Compass
Listen to Morningstar Australia's Investing Compass podcast
Take a deep dive into investing concepts, with practical explanations to help you invest confidently.
Investing Compass

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 research, returns repeatedly in an email exchange. ESG products and research are more focused than simply “doing good,” says MacMahon: They are much more focused, aiming to provide better, more comparable data and signals “to support the analysis of factors that previously were challenging for investors to analyse.” 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, say, Shell 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. 

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, the most popular iteration of which is called ESG investing, was a backwater in the investing landscape. That’s no longer the case: Investors are snapping up sustainable funds.

Divergent ESG ratings should converge as disclosure improves and as investors gravitate towards 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. 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 of Sustainalytics says.

is Morningstar's editorial director, sustainability.

© 2022 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'regulated financial advice' under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information, refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Morningstar’s full research reports are the source of any Morningstar Ratings and are available from Morningstar or your adviser. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782. The article is current as at date of publication.

Email To Friend