The Flaws of ESG for the Retail Investor

As a loyal reader of the QuantFu blog, no doubt you were captivated by our last entry about why you might consider environmental, social, and corporate governance (ESG) in your investment plans. ESG can be a useful framework for investors, but there are several drawbacks you should be aware of when evaluating and applying ESG to your investments.

One issue is that while ESG scores might seem numerical and objective, they are quite subjective. One rating agency’s ESG trash may be another agency’s ESG treasure. According to the Financial Times1, the correlations of assessments at major ESG rating agencies range from 0.38 to 0.71. For all of you who like me who nearly failed stats class, these correlations are terrible and much weaker than the 0.92 correlation between credit rating agencies’ assessments. There is not as much consensus on ESG in the investing world, and more work needs to be done to standardize assessments. 

And then there is the question about the credibility of the rating agencies themselves. Maybe you recall the 2008 financial crisis. Part of the cause of that crisis was the collapse in value of mortgage backed securities (MBS). If you want an entertaining rundown of how the housing market collapsed, watch The Big Short, but the short answer is that lenders sold lots of mortgages to people who had no business getting mortgages. These mortgages were then packaged into MBS and sold to investors. Ratings agencies assessed these MBS to be less risky than they actually were. The grossly inaccurate ratings became apparent as large numbers of mortgage defaults happened. Investors lost their shirts and families lost their houses. Not to be deterred, the rating agencies are now publishing lots of information about ESG. Buyer beware. 

To be fair to the rating agencies, determining if an action a company takes is good or bad for ESG is not so cut and dry. Think about the age-old ethical question about whether it is ok to steal bread to feed your starving family. In a real world ESG case, how do you evaluate a military contractor who donates equipment to help Ukraine defend itself against Russia’s invasion? Typically, military contractors don’t score high on ESG for obvious reasons. However, following Russia’s invasion of Ukraine, many defense contractors began helping Ukraine, which could boost ESG scores. The nature of the defense industry didn’t change- just global conditions and attitudes. Dilemmas like this show tension within ESG frameworks.

So, loyal reader, ESG can be an interesting and informative tool to help guide your investing, but it is an evolving discipline. Whether ESG metrics for companies are a true reflection of their impacts on society is an important factor in deciding how to incorporate it into your investing. You may decide that you trust the ratings agencies and you want to trade portfolios consisting of high-ESG companies. Or you might decide you simply want to follow your own judgment. Or maybe you aspire to be the next Bobby Axelrod and don’t care about ESG anyway. In any case, automating your trading with QuantFu gives you full control over your portfolio, allowing you to either invest in companies whose values align with your own or alternatively those that exploit profitable vices. 

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