What is an ESG fund? Learn all about this type of fund and why we think smart investors should avoid them in favour of this alternative strategy

What is an ESG fund? It’s been a long time since we first pointed out that when funds hold themselves out as “socially responsible investments” it helps the fund to sell units to investors, but it’s not doing the fund buyers any favours. In fact, these virtue-signaling funds have long tended to under-perform the market on the whole.

Along the way, these funds have undergone a name change (a re-branding, you might say). They now generally refer to themselves as ESG funds—for “environmental, social and governance funds.” The name change hasn’t done much for investors, but it’s been great for the fund sponsors. The ESG segment of the fund industry now manages and earns fees on investor funds worth $2.77 trillion U.S.

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What is an ESG fund and how can investors expect it to perform?

Andy Kessler, a former chip designer at Bell Labs who went on into the hedge fund business, is an occasional writer for the Wall Street Journal. One of his latest pieces is entitled “The many reasons ESG is a loser.”

The article quotes University of Colorado professor Sanjai Bhagat, writing in the Harvard Business Review, who makes four important points about ESG investing:

1. ESG funds have underperformed;
2. Companies that tout their ESG credentials have worse compliance records for labour and environmental rules;
3. ESG scores of companies that signed the UN Principles of Investment didn’t improve after they signed, and financial returns were lower for those that signed;
4. Companies publicly embrace ESG as a cover for poor business performance.

What is an ESG fund? An investment that could lead to “greenwashing”… and more

Mr. Kessler added that in May this year, German police raided the European offices of Deutsche Bank’s DWS unit in an investigation of “greenwashing”— the term for claiming that its investments were more sustainable than they were. The authorities claim, “We’ve found evidence that could support allegations of prospectus fraud.”

If this doesn’t put you off ESG funds, keep reading.

Soon after reading the Kessler article in the Wall Street Journal, I came across a piece in the University of Oxford (UK) law journal, on the subject of “variable interest equity structures” (or VIEs). The Oxford article says that for over two decades, Chinese issuers have widely used the VIE structure to raise overseas capital while, at the same time, “satisfying” China’s regulation of foreign investment in industries that are closed or restricted to foreign capital.

The article gave an example of how funds can pass from a typical Chinese-style VIE, such as a Cayman-incorporated listed shell company, to a China-based operating entity, through a package of contractual agreements rather than above-board investments. That way they can inject capital from the foreign entity into the Chinese company, via several conduit companies.

In other words, the VIE structure seems designed to sidestep Chinese legal restrictions on foreign investors. That’s not something you want to do in China or any authoritarian country. However, if the Chinese authorities decided to crack down on this particular maneuver, it could turn out to be more expensive now than it might have been a few years ago, when China was still trying to play nice with the west.

What is an ESG fund? A type of fund worth avoiding

We’ll stick with our long-time view: if you want to make money and do good with your investments, invest in so-called “plain-vanilla” investments that are not likely to run afoul of laws in China or anywhere else. That way you limit your risk and make more money for yourself. Then, if you wish, you can donate part of your profits to a cause you support, and get a tax deduction.

That way you’ll do more good for yourself and the charity of your choice, without contributing to the expenses of the fund sponsor.

Use our three-part Successful Investor approach for all of your investments—including ESG investments

1. Hold mostly high-quality, dividend-paying stocks.
2. Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
3. Downplay or stay out of stocks in the broker/media limelight.

Controversial ESG information is often omitted from reports. Why do you think investors still choose to buy these funds?

Do you hold any ESG investments? How has their performance changed over time?