The recent Cambridge Analytica scandal at Facebook has brought up an interesting question for ESG investors: if data privacy had been highlighted as a risk at FB, why did FB have such a high ESG score and why is it one of the top holdings of many ESG funds?
To answer the first question of why did FB have such a high ESG score, it may be helpful to review what ESG is and what it is not.
- Environmental, Social, and Governance (ESG) issues are risk factors and ESG scores cannot predict the future any more than financial metrics like price-to-book (P/B) or return-on-equity (ROE) can. Both financial and non-financial metrics can help investors tilt their portfolios, but they cannot help investors select individual winners and losers.
- Data on ESG factors is collected from many sources with varying levels of quality and completeness. The ESG ratings providers evaluate this data and provide both objective and subjective reporting. Just as investors should not blindly purchase investments with a five-star rating from Morningstar, investors should not blindly invest in something just because it has a high ESG score.
- Identifying risks is only half the battle. Accurately estimating a risk’s probability and its impact is the other half. BP had relatively high ESG scores prior to the Deepwater Horizon oil spill, as did VW before its emissions scandal and FB prior to the Cambridge Analytica debacle. Even though ESG risks had been identified, the perceived probability of the aforementioned events had been too low. That being said, estimating traditional financial risks or ESG risks is difficult (if not impossible) and surprises are by definition unexpected.
- Risk is only one side of the equation. Even if an investor had underweighted FB as recently as a year or two ago, that investor would have missed out on substantial returns. Such a person may argue that FB’s environmental (E) score more than compensated for its governance (G) score. A skeptic may say that the investor deemed the data privacy issues worth returns (especially in light of FB’s private data-dependent ad revenue and the relatively rapid rebound that we’ve seen in its share price from the scandal-driven selloff). Either way, ESG are a set of risk factors to be evaluated, not to arbitrarily exclude/include.
To answer the second question about why FB is a top holding of many ESG-themed funds, it may be helpful to think of ESG funds similarly to how we think about dividends funds or other factor-based funds. For those that rely solely on ESG scores or buy index funds based on ESG scores, it is important to understand how the sausage is made and understand what limitations exist. A familiar parallel may be the dozens and dozens of dividend-oriented index funds, which are constructed using a variety of methodologies. Why are some companies included in some funds and excluded from others? Investors should evaluate how their funds are constructed, what is in them, and decide if it matches their desired exposure. Whether a fund focuses on ESG, dividends, or anything else, I encourage investors to understand how the fund is constructed and what trade-offs exist. The simple answer is that FB is a top holding of many ESG indices due to how the indices are constructed; simply read the prospectus and you’ll discover how FB was included and weighted.
ESG analysis, like anything else in investing, is not easy. It’s a framework for thinking about risk rather than something that can be reduced to numerical score and blindly relied upon. At best, it helps investors make better decisions and incrementally improve the risk/return characteristics of their portfolios.
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