🔒 Why ESG funds fail, and how they could succeed – with insight from The Wall Street Journal

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Why ESG Funds Fail, and How They Could Succeed

A strategy of divesting from ‘dirty’ companies generates poor returns and little positive change.

By Terrence Keeley

Investments have consequences. Capital can be used to pursue technological breakthroughs, targeted rates of returns, or nonfinancial goals such as lower carbon emissions. Environmental, social and governance strategies have captured the imagination of many who want to do well and good—that is, to generate above-market rates of return and improve social and environmental outcomes. But to date ESG equity strategies have been broadly disappointing, underperforming common indexes while failing to generate meaningful progress against climate change. Many ESG strategies have been lose-lose.

“Temperature-aligned” funds illustrate how and why disappointment has been so common. These funds restrict investments to companies that have credibly committed to the Paris Agreement goal of net-zero carbon emissions by 2050. Depending on the verification process used, 175 to 225 companies in the S&P 500 fail to meet this requirement.

In practice, this means these funds overweight sectors such as tech and finance while underweighting sectors such as oil and gas. But holding less-diversified collections of shares has neither improved risk-adjusted returns nor helped decarbonize industries. Temperature-aligned funds have financially underperformed and failed to promote a more temperature-aligned globe.

Yet there is incontestable value in having more sustainable business practices. George Serafeim of Harvard Business School estimates that sustainable companies carry a 300-basis-point equity-valuation premium over nonsustainable companies. His research has two important implications. The first is that less-sustainable companies generally carry higher dividends. All else being equal, higher equity dividends will generate higher financial returns over time.

The second is that value can be created by turning “brown” companies “green.” Investors who want to do well and good should target dirtier industries and companies that have the greatest transformation potential, the opposite of temperature-aligned strategies. Capital providers must invest to achieve net-zero emissions, not divest.

Lower carbon emissions aren’t the only nonfinancial goals that ESG investors seek. Diversity, equity and inclusion practices are also common, as are economic-mobility and social-justice objectives such as better primary education and healthcare for underserved communities.

As with climate, however, the most effective way to get corporations to improve on these objectives is through active investment and stewardship. Impact investing also differs from common ESG investing because impact investors receive transparent reports with evidence that social or environmental progress has been made. Yet less than 1% of all investments in equity and debt markets are explicitly made for measurable impact. This is odd because successful double-bottom-line investing isn’t that hard. There are multiple investment opportunities that do well and good in a verifiable way.

Consider real assets. According to Cushman & Wakefield, midmarket offices with LEED certifications carry a 77.5% premium over noncertified offices. Upgrading buildings from “brown” to “green” would generate significant financial value. Similarly, building renewable energy plants or government-backed low-income housing units can generate high-quality income, which would make investment portfolios more diversified and resilient. The same can be said of green, social and sustainability-related bonds, emerging fixed-income asset classes that are growing quickly.

Venture-capital and private-equity investments dedicated to measurable impact have been shown to generate excess returns and verified social and environmental benefits, usually in terms directly linked to the United Nations Sustainable Development Goals. Bain Capital, the Sorenson Impact Foundation, TPG, Apollo Global Management and others have been able to generate double-digit returns on mission-related investments while providing underserved populations with better housing, healthcare and financial services.

Sound investment strategies consider time horizons, liquidity, risk tolerance and impact goals. All assumed risks should be intentional, sized to desired outcomes, and thoughtfully diversified. A decision to seek verifiable impact may or may not involve explicit financial trade-offs.

If an investor wants to do well and good, ESG strategies premised on divestment are likely to disappoint. There are many opportunities in the impact investment field that can generate outsize market returns and verifiable social and environmental benefits. Helping companies move from “brown” to “green” can reward your pocketbook, people and the planet. Providing transformational housing, education, healthcare, digital services and financial access to underserved communities can generate significant financial returns.

Mr. Keeley is chief investment officer of 1PointSix LLC and author of “Sustainable: Moving Beyond ESG to Impact Investing.” He was a senior executive at BlackRock, 2011-22.