By Harriet Evans, Investment Analyst at Church House Investment Management

Socially responsible and sustainable investing has notably outperformed more straightforward peers since the pandemic struck earlier this year.

This outperformance has accelerated the existing long-term trend towards sustainability, which, over this period, has been helped by being overweight in technology and underweight in energy and industrials, given the shift in technology and collapse in oil and industrial stocks brought about by the recession. The rise in popularity has been fuelled by increased investor appetite for socially conscious investing, alongside greater returns. Net global inflows of funds aligned to ESG principles amounted to over $7 trillion between April and June – more than the total inflows in the five years prior, according to the FT.

While the spotlight has previously been on the ‘E’ (Environmental) side of ESG, the ‘S’ (Social) angle has now been brought to the foreground. The focus on how companies have responded during this difficult time in relation to corporate responsibility, namely the well-being of their employees, communities and supply chain management, alongside robust long-term strategies, has been increasingly highlighted. In turn, this has facilitated investors in differentiating between companies which view their stakeholders as long-term assets and those focused on short-term profitability.

While ESG and sustainable funds have been thriving, the criticisms of this investment approach’s arguable over-reliance on ESG ratings has also been brought to the surface.

Outsourcing ESG ratings to external agencies, without sufficient first-hand research, carries certain problems, such as the awarding of potentially unjustifiably high scores to some companies. A recent example includes fast fashion clothing company, Boohoo, which, until June, was rated AA by MSCI with 8.4/10 for labour standards in their supply chain – substantially higher than the industry’s average of 5.5. These high scoring systems led many sustainable funds to have Boohoo among their largest holdings until news broke in July of allegations of poor working practices, with workers in Leicester being paid a mere £3.50 an hour.

Complex ESG scoring structures by ratings providers, which can allow for poor scoring in one area to be compensated by strong scoring elsewhere, can overlook red flags in crucial areas, such as human rights and health & safety. Chasing high ESG scores could perhaps be creating an unfounded bubble for certain companies and draw fund managers down a misleading path. Significant high costs for third-party ESG research and ratings also needs to be taken into consideration.

Another issue with ESG ratings is their lack of consistency with no standard method of evaluation yet established, as well as variances due to subjectivity impacting the weighting of factors; the same company can score highly by one ratings agency and poorly by another. These discrepancies in ratings with low correlations between top providers can be seen with Tesla, which is rated among the bottom 10% of businesses by JUST Capital vs an ‘A’ rating from MSCI; the difference in this case is attributable to the importance weighting given to workers’ rights vs carbon footprint. For this reason, preference is moving towards raw ESG data rather than ESG scores. Smaller companies are also more susceptible to their ESG ratings being non-representative due to lower disclosure. Reliance on companies to be aware, accountable and disclose data is also something to be mindful of.

The materiality of ESG issues varies by company and industry and often, these principles can be best implemented by adopting a holistic view and engaging in regular dialogue with investee companies. In essence, by getting out on the road, visiting company sites and meeting management teams.

The movement towards those wishing to have their money invested in sustainable companies with healthy working practices is positive and a welcome opportunity in driving much needed change for the better, alongside increased accountability and transparency. Sustainable investment allows for more resilient societies and businesses and ultimately protects both returns and our environment but an over-reliance on ratings that have been evaluated with a distinct lack of any ‘common standard’ could ultimately be damaging to investors.