Investing Responsibly: ESG and the Well-Intentioned Investor

No matter how one refers to it — “ESG” (environmental, social and governance), “responsible” or “sustainable” investing — the world is paying increased attention to investment decisions that include nonfinancial factors not captured by traditional accounting methods.1  These factors include a firm’s environmental impact (e.g., carbon emissions, pollution, resource use), how it manages its stakeholder relations (e.g., with its customers, workforce and communities), and its governance standards (e.g., alignment of management incentives and board structure).

We witness with seeming regularity the importance of ESG factors through such high-profile incidents such as Enron’s fraud (2001), the VW “Dieselgate” emissions test scandal (2015) and Facebook’s personal data privacy breach (2018). The COVID pandemic also brought many workplace and social controversies to the forefront.

This all raises the question of how exactly investors should consider ESG in their decision-making processes.

Navigating such issues is especially challenging in a world in which most of us do not invest directly ourselves, but rather delegate our investment decisions to others, perhaps mutual fund or pension plan managers. Collectively referred to as “institutional investors,” these managers now own close to half of all publicly traded equity shares worldwide.

Some of these managers signal their acceptance of ESG investment principles by signing pledges such as the Principles for Responsible Investing (PRI), the U.N.-supported global network of signatory institutions, which currently represent over $120 trillion in assets under management. The rapid growth of the PRI and other ESG initiatives have led many industry observers to project that ESG investing will become mainstream in the not-too-distant future.

ESG Investing at a Crossroads

Despite all its progress, ESG finds itself at a crossroads.

One issue it faces, for example, is what is commonly referred to as “greenwashing.” This cleverly labeled term describes cases in which institutional investors (mis)label products — perhaps a mutual fund claiming to incorporate ESG factors — while in reality, the bulk of its investments fail to actually incorporate ESG.

This issue came to the fore in 2022 when the U.S. Securities and Exchange Commission fined firms such as BNY Mellon and Goldman Sachs Asset Management for various ESG-related misstatements. Additionally, the German regulator BaFin investigated DWS Group (formerly Deutsche Asset Management), which resulted in police raiding the firm’s offices to gather information.

An anti-ESG movement may be on the rise, particularly in the U.S., with an effort among a few states led by conservative legislators. As an example, Blackrock received a letter concerning the state pension plans, challenging its prominent use of ESG criteria in making its fund investments. The criticism was that Blackrock — the largest asset manager in the world — had a “fiduciary duty” to consider only financial returns in its decision-making, leading some state treasuries to announce asset withdrawals from the asset manager.

Do Institutional Investors Around the World ‘Walk the [ESG] Talk?’

In light of this ongoing debate, questions arise regarding how institutional investors actually go about implementing ESG principles. Questions such as: For those institutional investors who commit publicly to invest responsibly, do they actually do so in practice? Furthermore, do these practices translate into desirable ESG portfolio outcomes? These are important questions to investigate, as after all, the goal of responsible investing — allocating capital toward companies that make the world more sustainable — is only possible if investors live up to these commitments.

UVA Darden Professor Pedro Matos, the James A. and Stacy Cooper Bicentennial Professor of Business Administration, John G. Macfarlane Family Chair and academic director of Darden’s Richard A. Mayo Center for Asset Management, examined this question recently in Do Responsible Investors Invest Responsibly?2  The paper was recently featured in The Economist magazine, as well.3

Matos and his co-authors investigated equity portfolios around the world to compare PRI-signatory institutional investors versus their non-PRI signatory counterparts. They also examined a unique PRI reporting dataset that allowed them to classify signatories across three groups: full, partial, or no ESG incorporation. Matos said they were curious about whether PRI signatory institutions “walk the talk” in terms of integrating ESG into their equity portfolio holdings.

The study compared what PRI signatories reported doing (in terms of ESG incorporation disclosed in their annual PRI reporting) versus their actual portfolio ESG scores (that quantify the extent to which their portfolio holdings reflect their ESG pledges). In other words, how sustainable are the stocks included in a PRI institution’s portfolio as compared to their non-PRI peers? In taking this approach, Matos and his co-authors revealed that responsible investors (PRI signatory institutions) in fact do invest more responsibly than non-PRI institutions. They concluded the following:

Globally, external to the U.S., signatories with even partial incorporation of ESG frameworks into their active equity holdings have better portfolio ESG scores than non-PRI signatories.

The study also illuminated interesting ESG incorporation approaches around the world. For example, ESG “screening” strategies (i.e., favoring or excluding stocks based on ESG criteria) are more commonly used in Europe, while ESG “integration” strategies (i.e., the inclusion of ESG factors into financial analysis, portfolio construction and risk management) are more popular among institutions in the U.S. and other parts of the world.

A Transatlantic Divide

Matos and his co-authors revealed that outside the U.S., investment firms generally walk the talk when it comes to following through on their responsible investing pledges. On the other hand, in the U.S., they observed a substantial disconnect:

Matos and his co-authors did not find improved portfolio ESG scores for PRI signatories in the U.S., including for those firms that report full ESG incorporation.

In fact, U.S. investment firms that signed the PRI but then did no implementation of ESG factors actually had worse ESG portfolio scores on average than U.S. investment firms that did not sign the pledge.

Matos expressed concerns that this could indicate pervasive greenwashing in the U.S. and speculated that their findings could be driven by a combination of factors:

• Higher commercial incentives to become a PRI signatory
• The regulatory uncertainty as to whether ESG investing is consistent with “fiduciary duties” that binds asset managers
• A less mature market and hence less pressure for ESG implementation in the U.S.

Moving Forward

Overall, Matos and his co-authors’ results highlight that, especially in the U.S., retail investors would be well-advised to do more than simply rely on the “PRI signatory” label alone. This means conducting additional due diligence when evaluating a potential investment manager.

Matos advises investors to look beyond simple ESG credentials and attempt to assess the extent of alignment between their asset manager’s responsible investing commitments and their actions. This approach not only would benefit retail investors, but could also perhaps enable a less politically charged discussion around ESG investing both in the U.S. and abroad.

Pedro Matos co-authored “Do Responsible Investors Invest Responsibly?” which appeared in the Review of Finance, with Rajna Gibson Brandon of the University of Geneva, Simon Glossner of the Federal Reserve Board, Philipp Krueger of the University of Geneva and Tom Steffen of Osmosis Investment Management.

This article was developed with the support of Darden’s Richard A. Mayo Center for Asset Management, at which Pedro Matos is academic director and Aaron Fernstrom is director.

• 1Pedro Matos, “ESG and Responsible Institutional Investing Around the World: A Critical Review,” CFA Institute Research Literature Reviews, 28 May 2020, https://www.cfainstitute.org/en/research/foundation/2020/esg-and-responsible-institutional-investing.
• 2Rajna Gibson Brandon, Simon Glossner, Philipp Krueger, Pedro Matos and Tom Steffen, “Do Responsible Investors Invest Responsibly?” Review of Finance 26, No. 6 (November 2022), Pages 1389–1432, https://doi.org/10.1093/rof/rfac064.
• 3“Dubious Green Funds are Rampant in America,” The Economist, 1 December 2022, https://www.economist.com/finance-and-economics/2022/12/01/dubious-green-funds-are-rampant-in-america.