Investing in a portfolio aligned with ESG values is near impossible and investors should focus on aligning their portfolios with either environmental, social or governance principles.
This is according to a report from the Bank for International Settlements entitled ‘deconstructing ESG scores: how to invest with your own criteria’, which aimed to work out if an investment manager could construct a portfolio of equities that achieves a certain financial performance with “better” underlying ESG characteristics.
It said it aimed to circumvent the “inconsistencies” of ESG scores by focusing on the underlying data points of investments.
The report concluded that devising investment strategies based on ESG factors has been a “practical hurdle, especially given the potential for weak scores in one pillar to be offset by strong scores in another pillar.”
It added: "We investigate[d] the characteristics of the various categories of ESG factors and find that they do not all contain the same quality of underlying information – and hence may not have the same desired positive impact from an investment perspective."
Furthermore, if investors are to undertake a screening process to exclude firms that do not align with ESG values, the end portfolio results in significant regional and sectoral biases relative to the benchmark.
This would not be acceptable for investors looking to hold a passive portfolio, it added.
The benefits of shifting focus from ESG towards more granular sustainable or moral portfolio characteristics would be that investors will not suffer from the “aggregate confusion” created by consolidated ESG scores or ratings, and will instead focus on the factors that are most relevant to their investment mandates.
Focussing on individual themes would also help investors better track the sustainability performance trajectory of their investments in relation to their states sustainable investment objectives.
"Finally, over time, the focus on themes would also enable investors to develop their own ESG assessment models using actual and observed third-party vendor data, thereby overcoming vendor-specific concerns."
Advisers have been struggling amid a lack of transparency on environmental, social, and governance definitions as they wait for regulatory clarification, experts warned earlier this year.
There is concern that, in the absence of any regulatory-approved definitions on what should make up an ESG or sustainable fund, the advice profession is feeling the lack of definitions the hardest.
Advisers are also worried they will be judged on asset allocation decisions made today by criteria developed in the future.
There are currently no rules in the UK on what qualifies as a ESG or sustainable fund.
The FCA will soon require advisers to take sustainability issues into account when advising clients, and it is currently consulting on criteria to classify and label investment products for firms involved in investment management and decision-making processes.