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Sustainable Investments – Etfs Are Not A Good Solution

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Sustainable investments based on so-called ESG criteria are trendy. More and more corresponding exchange-traded index funds (ETF) are coming onto the market. But the valuation concepts they screen companies by lead to questionable results. Since the climate protection activist Greta Thunberg became a media star, a lot has been said and written about sustainable investments. Investing money in stocks and bonds these days isn’t just about generating income. The investment should also be environmentally and socially responsible.

It was very different 15 years ago. There was barely anyone involved in environmental investments at the time. Environmentally and socially responsible investments were considered a passion of well-heeled nuts. Today they are trendy. Fund companies and ETF providers sense a growing market in which everyone is involved – and of course always wants to be at the fore.

Ultimately, anyone can claim such advertising claims with impunity, because what sustainable investments are is not clearly defined. That makes it so difficult for private investors to invest in this segment. Each product provider sets its own standards, some of which differ significantly from those of the competition. If you want to know which equity fund invests according to criteria that match your own ideas, you have to do extensive research.

Sustainable investments: strategies at a glance

The most widespread strategy worldwide and in Europe for creating sustainable investment products is the so-called negative or exclusive screening , determined the Global Sustainable Investment Alliance (GSIA), a global association of regional initiatives to promote sustainable investments. Negative screening excludes companies and industries whose business areas parts of society consider unethical and harmful. These include the alcohol, tobacco and gambling industries, as well as gun and pornography producers.

Some fund providers also exclude industries that are particularly harmful to the climate, such as companies that make their living from the extraction of fossil fuels such as coal and oil. Even corporations that attract attention because of the use of child labor or other violations of human rights can end up on the exclusion lists of providers of sustainable investments. Likewise, companies that use tricks to avoid tax payments that violate environmental laws or whose business practices include corruption.

Positive Screening: The ESG Criteria

Another approach is “positive screening” . Companies from individual sectors are rated according to ESG criteria. For a fund, the manager then selects either the best of their respective peer group (best-in-class) or the companies that have made the greatest progress in implementing better ESG standards (best-in-progress).

ESG stands for environmental, social and governance, i.e. for the environment, social affairs and corporate management . These three areas are assessed during the screening on the basis of a large number of individual criteria. From the results, data providers calculate an overall rating called an ESG score or ESG rating . The following list by Hypovereinsbank shows an example of a selection of individual ESG criteria:

Environment: Investments in renewable energies, efficient use of energy and raw materials, environmentally friendly production, low emissions to air and water, comprehensive climate protection strategies.

Social: Compliance with central labor rights, e.g. prohibition of child and forced labor as well as non-discrimination, high standards of occupational health and safety, fair conditions in the workplace, appropriate remuneration as well as preparation and opportunities for higher education, freedom of speech and trade union, regulation of retailer social norms.

Corporate management (governance): efficient supervisory and decision-making structures, transparent measures to prevent corruption and bribery, anchoring sustainability management at board and supervisory board level, linking board remuneration with the achievement of sustainability goals, dealing with whistle blowing.

Another strategy is what is known as ESG integration . With this approach, fund managers incorporate ESG ratings into their normal stock selection process. ESG factors are an evaluation criterion among many other key figures in classic company analysis. According to the GSIA, this concept is most commonly used in Europe alongside the exclusion process.

ESG criteria: No uniform standards

ESG ratings can only be as good as the underlying data. The American asset manager Research Affiliates complains, however, that they are not infrequently inadequate because they are partly based on information provided by companies and there is sometimes a lack of analysts who scrutinize corporations.

The investment company has identified 70 companies worldwide that offer ESG data . Some are specialized, for example in calculating the carbon dioxide emissions of companies, or only supply processed raw data obtained from publicly accessible sources. Others such as the index provider MSCI provide ready-made ESG ratings.

Is Walmart a sustainable company or not?

Take Walmart, for example.The analysts of the data and index provider FTSE have given the American supermarket chain a first-class ESG rating. At MSCI, however, the retail giant lands in the lower quarter. The two ESG rating providers only largely agree when assessing the environmental standards. In the areas of social affairs and corporate governance, FTSE gives top marks, while MSCI comes up with very low ESG scores. Sustainable investments, regardless of whether they are ETFs or actively managed funds, are not investments that are compiled according to objective criteria. Rather, the subjective view of rating and product providers dominates.

Investors who want to invest sustainably can therefore not avoid dealing with the complex selection process of the individual providers. This is the only way to find the ESG products that best suit your personal point of view.

Return on sustainable investments

The financial industry and some media like to advertise that sustainable investments are not only “good for your conscience”. They should also bring higher returns than conventional systems. The research found that there is no clear evidence of this so far. A large number of studies exist that deal with the question of whether sustainable investments achieve higher returns than conventional investments or whether investors have to expect discounts. But according to the scientists, the results contradict each other. They strongly depended on the period examined. Because ESG investments are still relatively new, the time series are too short to come to a reasonably reliable judgment.

Sustainable Exchange Traded Index Funds (ETF)

There are now more equity ETFs listed on different countries’ stock exchanges that invest sustainably. According to the Scope rating agency , two thirds of these are indexes from the MSCI provider. Its designers have created standard indices that are compiled according to various sustainable criteria:

ESG-Universal: Based on market capitalization, companies with better ESG ratings are overweighted and corporations with poor ratings are underweighted. The change in the ESG score is also taken into account (best-in-progress). MSCI completely rules out the stocks with the worst ratings.

ESG Screened: With these indices weighted according to market capitalization, controversial sectors are excluded (negative screening).

ESG Leaders: Exclusion of controversial industries. Of the remaining companies, the 50% with the best ESG rating are selected from the individual sectors and countries (best-in-class). Weighting according to market capitalization.

SRI: The acronym stands for Socially Responsible Investment. The SRI indices are structured like the ESG leaders. However, only the top 25% of companies are included in the indices.

When constructing ESG indices, MSCI always uses a conventional index, such as the MSCI World . These parent indices represent the investment universe, which is then reduced to controversial sectors and less sustainable companies with the help of the ESG filters.

How sustainable are ESG ETFs really?

Example MSCI World SRI Index . In contrast to the classic MSCI World Index, which contains more than 1,600 corporations, this sustainability variant only includes just under 400 companies. According to MSCI, companies that earn their living from nuclear power, tobacco, alcohol, gambling, weapons, genetic engineering, coal and pornography were initially excluded. The index provider screened the remaining stocks using its ESG criteria according to the best-in-class procedure. The bottom line is that such an approach leads to questionable results. For example, the MSCI World SRI Index contains a number of oil companies , such as Total, and suppliers to the petroleum industry. Even mining companies that operate gold mines are represented. With the conventional extraction of gold , however, toxic substances such as mercury are released, which are harmful to people and the environment.

Auto Industry – An Environmentally Sound Investment?

According to MSCI’s ESG rating system, the auto industry is also an environmentally friendly investment. Only Tesla and Honda are represented as vehicle manufacturers in the MSCI World SRI Index. But there are some supplier companies, such as the car tire manufacturers Michelin and Pirelli.

Pepsico is one of the top ten companies in Index . The group produces sugared lemonades, which promote obesity among consumers. Obesity, in turn, can lead to significant health problems such as cardiovascular disease. MSCI also classifies its competitor Coca-Cola as a sustainable investment . So does Kellogg , a manufacturer of high-sugar grain products that millions of people eat for breakfast every day.

How sustainable are banks?

Banks and insurers are a black box for investors who want to invest sustainably. Whether financial service providers do business with questionable companies and countries cannot be seen from the outside. Every now and then it is only by chance who knows who has got his finger in.  It would be naive to think that globally competitive financial service providers will encourage themselves to operate solely on legal, socially and environmentally compatible standards. Investors should be aware that any dirty deal on the planet involves financial firms. In this respect, this sector is also questionable.

MSCI and other companies also offer ESG indices that are even stricter than the MSCI World SRI Index. This includes the variant MSCI World SRI Select Reduced Fossil Fuels, in which the weight of the oil industry is significantly reduced. But the other companies from the MSCI World SRI, whose environmental and social standards are in doubt, are still represented.

What do sustainable investments do?

For investors, the question arises as to what effect do sustainable investments actually have? What will happen if more and more investors don’t buy shares in oil companies, for example. First in first, it should be noted that there will always be investors willing to hold these stocks as long as they generate income. When demand falls, these companies’ share prices fall. But that doesn’t change the world.

But if you follow science, lower stock prices lead to higher financing costs. Companies are financed either through loans or through the issue of shares or a mixture of both. The cost of equity is measured by the dividend yield , the amount distributed in relation to the share price . If the share price falls for a given cash flow from dividends , the dividend yield increases, which in turn increases financing costs. Studies show a negative linear relationship between the cost of capital and capital expenditure. As financing costs increase, expenses for new projects and equipment decrease. In relation to oil companies, this would mean that they may invest less money in environmentally harmful projects.

Fair value recommendations

Sustainable investments are a subjective matter. The particular point of view is a matter of where the fault line runs between good and poor firms. ETFs that invest according to ESG criteria are not very suitable for implementing a sustainable investment strategy. The ESG indices that track ETFs contain too many companies that, in our opinion, are not suitable for sustainable investments.

If you really want to invest sustainably, you should switch to actively managed funds , which we normally advise against, with more concentrated portfolios and / or individual stocks . But the more corporations and industries exclude investors from their personal investment universe, the higher the risks, because fewer and fewer modules are available for diversification . This applies to pure equity portfolios as well as to mixed portfolios from different asset classes.

Hello, I have been working as an investment consultant and author for more than 20 years. I love what I do and I have enriched everyone around me. A lot of money is not important, the main thing is how you use the money.

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