How flawed is ESG investing? What happens when effective altruism fails like it did for FTX and its founder, Sam Bankman-Fried?
In Tayler Swift’s beloved new song Anti-Hero she asks the listener “Did you hear my covert narcissism I disguise as altruism?”
According to Billboard.com the song is meant to take fans “deep into her mind” to explore her own insecurities. Although Swift talks about this song as being deeply personal, Swift may be capturing the cultural zeitgeist of the moment as her question comes at a time when virtue signaling and effective altruism are increasingly under fire due to the spectacular crypto crash in early November of the cryptocurrency exchange FTX.
Its founder, Sam Bankman-Fried, who goes by SBF, allegedly committed fraud while claiming to customers, investors and politicians that the only reason he wanted to make money was to do good for the world. As the true extent of the crash became public knowledge everyone got a peak behind his disguise and it wasn’t pretty.
Each of us makes choices daily that we hope will be good for humanity, good for our neighbors and good for our family. When making those choices we rely on knowledge experts, government entities, regulatory bodies, etc. What happens though when we realize those frameworks might not do enough to protect us even though we are trying to do our part in bettering humanity?
Inconsistencies in ESG ratings
One of the interesting stories that emerged from this bankruptcy circled around the concept of ESG investing and its problematic rating system. If you are in the financial services industry or an active investor it is likely you have heard of “ESG.” Although most agree that the initials ESG stand for “Environmental, Social & Governance” that seems to be where the agreement ends.
Some define ESG as a set of standards for a company’s behavior used by socially conscious investors to analyze potential investments while others see ESG’s aim as the “attempt to measure a company’s or portfolio’s long-term exposure to environmental, social and governance risk factors.”
These ratings are used by fund managers to include or exclude companies in their ESG investing basket. In other words, when you decide you want a certain percentage of your investment portfolio to go only to companies that are doing good things for the environment, you would likely double-click on the ESG basket. So, regardless of the lack of a cohesive definition, these ratings have been used to market investment funds, companies and individual investments as socially conscious, good for the environment or generally “virtuous.”
An article from the Harvard Law School Forum recently argued that ESG ratings are a ”compass without direction” due to the industry’s high fragmentation “with dozens of ratings agencies and data providers in existence,” all of which use differing definitions and methodologies. For example, some ratings agencies give one overall rating while other agencies rate each component separately resulting in huge variation and low correlation in ESG ratings in contrast with the high correlation of, for example, credit ratings issued by the 3 credit reporting agencies.
Which direction is due north?
On the face of it, this ratings system, or lack thereof, may seem harmless, but in reality these ratings can determine in which companies you choose to actively invest (to your own detriment), which companies land in the ESG bucket of your investment portfolio, which companies garner large investments from VCs and which companies come under scrutiny either in the media or with regulators. And, in a year where most investors have lost money, those underlying assumptions are coming into question.
The example of FTX, who did not have a functioning Board of Directors and received a higher ESG rating for Governance than a well-known public company, illustrates the danger and bias of these ratings. There are likely a million creditors in the FTX bankruptcy and many of those people feel duped by SBF and by the ESG rating system. You may believe you have immunity by avoiding risky bets, but you may be surprised to find out that that the Biden administration recently issued a rule allowing your company to weigh ESG factors when choosing investments for your 401(K).
Many have lost money in the markets this year due to speculation and as the bubble busts more of these incongruities will materialize. So, it may be time to take a peek into our investments to be sure we are putting our money where our mouth is and not just “performing” social consciousness. In other words, self-reflection and validation of our assumptions should be on the menu, because if not, we might find ourselves victims of a wolf disguised in ESG-clothing.
Mortgage Industry Strategist Melody Wright began her mortgage career at GMAC ResCap (RFC) in 2006 and helped manage the historic ResCap bankruptcy. After leaving ResCap and before joining the FinTech revolution, she focused on operational effectiveness at multiple large, nonbank servicers. A 24-year BFSI industry veteran, Melody currently focuses on mortgage FinTech and macroeconomics, working hand-in-hand with clients to design and implement integrative solutions in mortgage origination and servicing that will be successful amidst the ever-evolving economic landscape.