Tens of thousands of funds that have changed nothing about their investment approach are about to see their environmental, social and governance scores lowered—a poor look for an $8.4 trillion market in the U.S. that’s struggling to be seen as bona fide.
MSCI Inc., regarded as ESG’s most influential gatekeeper, recently said it’s overhauling the way it evaluates some 31,000 exchange-traded and other funds, resulting in the sweeping downgrades. As a result, just 54 funds will have the highest ESG rating, or AAA, down from 1,120, according to the Financial Times. More than 400 ETFs that use swaps will lose their ESG score entirely as MSCI reconsiders how to assess them.
The changes seem positive on the surface—MSCI clearly had a problem with grade inflation. But they come as the ESG ratings industry faces criticism for a myriad of faults, not least of all from investors who have been burned time and again by the very risks they pay a premium to avoid. Think the recent scandal surrounding the business empire of Indian billionaire Gautam Adani, whose two group companies were included on several ESG indexes, or the rush to exit Russian assets that had been labeled ESG.
What MSCI’s move actually shows is how problematic ESG ratings are in the first place. How can black-and-white ratings apply to something like ESG, which can mean so many different things? More regulation of the industry is needed, for sure, but ratings as they’re currently devised aren’t the answer. Ultimately, ESG scores—even if they’re new and improved—do investors a disservice because of the gap between investor expectations and the approach taken by different firms.
On corporate ratings, MSCI, for example, ranks an issuer’s ability to manage financial risks from ESG factors, while other providers often take a broader approach that incorporates companies’ impact on the communities in which they operate. It’s no wonder then that different ratings providers may give funds or individual companies wildly divergent grades. An MIT study found that the correlation among the most prominent ESG ratings firms is just 0.54 on average, compared with 0.92 for the large credit ratings agencies. Bloomberg LP, the parent of Bloomberg News, also provides ESG scores.
Plus, the methodologies of what goes into the ratings remain relatively opaque, raising more questions than answers for an investor who goes digging. And as policymakers turn their attention to this loosely regulated slice of the market, who’s to say MSCI or other ratings providers won’t be changing their criteria again in another few months?
Those assigning ESG ratings for companies and funds are acting like the credit ratings agencies of the corporate finance world. Aniket Shah, Jefferies Financial Group Inc.’s global head of ESG and sustainable finance strategy, points out that, despite numerous failures, the credit ratings firms are at least all answering one common question: Can a borrower repay?
With ESG, it’s not so clear-cut—ratings providers are all trying to answer different questions, which makes assigning ratings totally futile. On top of that, they’re dealing with information that’s less accessible and standardized.
Ultimately, MSCI’s overhaul is going to make people even more suspicious of ratings, and decrease the credibility of the industry overall. A 2022 study by Capital Group found that a lack of consistency in ESG ratings among different providers was cited as the No. 1 challenge for institutional clients when implementing ESG investments.
That sort of sentiment isn’t going to help with flows, which have suffered lately after going gangbusters. In 2020 and 2021, the organic growth rate (defined as net flows as a percentage of total assets at the start date) of sustainable U.S. funds was more than 30%, according to Morningstar Inc. Last year, the organic growth rate plummeted to just 0.9%.
Aside from the larger issue of why we even have ESG ratings, MSCI’s reassessment is sure to lead to some upheaval in the short-term. Remember, most of these funds aren't just broad-based ETFs tracking the Standard & Poor's 500 Index. They're niche funds, where managers have worked with MSCI to create bespoke indexes.
That means many fund managers will be scrambling now to make changes so their funds are in line with whatever ESG ratings they’ve promised investors, says Adriana Robertson, a professor of business law at the University of Chicago.
There’s going to be far fewer options around for retail investors intent on putting money in top-rated ESG funds, or for institutional investors, such as European pension funds, which may be required to. As a result, a lot of money could get reallocated to just a handful of funds. Hello, concentration risk! Plus, the changes could drive up the prices of the underlying assets of those AAA-rated funds.
What’s the answer then? For institutional investors, it probably means doing their own homework to see if a fund or company is meeting whatever ESG means to them. That’s not practical for individuals, which is why stricter regulation by European and US regulators is needed, especially when it comes to labeling.
Until then, investors would be better off just ignoring ESG ratings; no grade is better than a dubious one.
Alexis Leondis is a Bloomberg Opinion columnist covering personal finance. Previously, she oversaw tax coverage for Bloomberg News.