Ethical investment is booming. But what is it?

“ESG” investment is hard to define and its returns are hard to measure

MAYBE weary of its role as a punchbag for moralists, and certainly in search of products with widespread appeal, Wall Street has taken to selling products linked to virtue. That is not easy: how does an industry focused on financial returns go about gauging goodness?

The approach started years ago with funds that called themselves “socially responsible”. More recently the terminology has evolved, with many claiming to pursue “ESG” investing, standing for “environmental”, “social” and “governance”.

Morningstar, a data-tracking firm, places any fund that uses terms such as sustainable investing, ESG and so on in its prospectus into a category that now has 204 members with $77bn in collective assets. The oldest fund in the Morningstar group dates back to 1971. But nearly half have been launched in the past three years. More quietly, the wealth-management offices of many American investment firms constantly roll out investments touting these sorts of characteristics and Morningstar counts in excess of 2,000 funds worldwide. Endowments and pension funds, the big global money pools, are beginning to suggest they, too, want to invest along these lines.

Two perennial questions have accompanied the deluge of money. The first is whether the approach comes with special costs: ie, is there a virtue discount? Second is the question of what should be measured. Neither is easy to answer.

One attempt to answer the first looked at the converse: were returns higher for shares that would not qualify for inclusion in these efforts: in other words, is there a vice premium? Lists were compiled of “sin stocks”, usually involving tobacco, alcohol and gambling, but sometimes firearms and the like (a future one might add fossil-fuel producers and defence companies). A paper published in 2009 called “The Price of Sin”, by Harrison Hong and Marcin Kacperczyk, two academic economists, concluded that there were indeed unusual returns in firms that sold tobacco, alcohol and gambling.

However, a second paper published this year (“Sin Stocks Revisited”, by David Blitz of Robeco Asset Management and Frank Fabozzi of EDHEC Business School) contests these results. It argues that added risk factors such as low reinvestment rates mean that there is no evidence that sin stocks provide a premium for reputation risk. Robert Whitelaw, a professor at New York University’s Stern School of Business, says that the conflicting analyses reflect the broader results of more complex efforts aimed at tracking results from (“virtuous”) companies that would qualify for these funds. Results are mixed.

It would help if there were an easy answer to the second question: what really determines an ESG company? Of the three categories represented by the initials, the clearest is the first. The environmental “E” means shunning companies that produce a large amount of externalities—costs not captured in the manufacturing process—like carbon or waste or other forms of pollution. The ���G” for governance encompasses an evaluation of how the company structures its board, disclosure, compensation and so on.

Neither area is straightforward. But the complexity of each pales in comparison with that involved in exploring what lies behind the “S” for social. This often involves labour rights, such as working hours, wages and fatalities, and the ability to pursue a grievance; and issues such as the breakdown of employees by gender. Hundreds of different outside services analyse how companies tackle “social” issues. A study by NYU’s Stern School (“Putting the ‘S’ in ESG”) looked at 12 of the most popular approaches. It extracted from these more than 1,700 different measures. Companies seeking to respond to these evaluators faced a daunting task: answering 763 questions for companies involved in food and beverages; 698 for companies in extractive industries.

A consequence is that even companies willing to complete surveys are overwhelmed by the task. And the answer they provide is often incomplete anyway, because it overlooks their supply chains. The NYU survey notes that many current approaches ignore the full supply chain and thus often the hard end of manufacturing. Or they judge companies on their stated intentions, such as promising to ask suppliers to treat labour well, without actually monitoring or reporting the results.

That this category struggles to live up to its idealistic promises justifies some scepticism. But, at the very least, it is focusing attention on the problems and hence applying pressure for a better approach. It is also refining definitions of terms for investing that may have value elsewhere, and help replace feel-good bromides with crunchier measures. NYU is planning its own indicators for “social” factors. It wants them to be simple—a dozen factors. That it and others are exploring new approaches must, in itself, be a social good.