Boohoo and the failure of ESG ratings

In the aftermath of the Boohoo revelations, questions have rightly been raised as to why significant numbers of ESG funds were holders of the stock.

Reliance on ESG ratings is not enough

Attention has been drawn to the relatively high ratings that Boohoo had achieved with ESG rating services. MSCI gave Boohoo an AA rating, which appears to have given some ESG fund managers the approval they needed to invest in this stock. Aberdeen Standard were notable amongst being the largest holders. To my mind this highlights the gulf between the processes and philosophy of different ESG managers. The extent to which managers attach importance to ESG scores is a reflection on the extent to which managers really buy into Values-based investment, and the extent to which they are content to delegate responsibility for their Values-based judgement.

What is wrong with ESG ratings?

ESG scoring mechanisms have significant drawbacks when it comes to applying outputs in a practical investment sense. The first of these is that ratings are a compilation of an exceptionally large number of different metrics meaning that the relative importance any one metric (however critical) can become enormously diluted. Secondly, companies tend to be rated on their behaviour relative to companies in the same industry thus creating a “best of a bad lot” culture. The Boohoo incident also reveals managers such as Edentree who simply distrusted the industry’s ability to keep their supply lines clean and therefore avoided the sector completely. Thus, there is plenty of scope for relying on personal judgement.

Values and detective work count

The reality of ESG research is that it requires substantial judgment and detective work. The first of these will be lacking if the fund managers themselves are not entirely bought into the values they claim to represent, and the second is time consuming and therefore expensive work. With more and more asset managers claiming to integrate ESG into their process, it is becoming more and more important for investors to understand how the analysis is done and the relative importance that is attached to it. In my opinion, many ESG managers see this as balancing risk and reward. By this I mean that they seek to understand the impacts of ESG related events and translate that into a quantified financial risk. If you can do this, you can create a financial equation that tells you whether the stock is worth owning or not. I would argue that this is not values based investment - this is an extension of the way asset management has always been done. Ironically, this sort of analysis might even incentivise profit maximisation from bad behaviour.

What you should look for in an ESG manager?

So, what should investors look for when they are selecting an ESG investment manager? I would suggest the first would be to look at the values system of the fund management company and the fund management team. This should give you a clue to the extent the managers buy into values-based investment. Secondly, I would look at the extent to which the managers place reliance on Ratings agencies versus reliance on their own in-house analysis. Lastly, a look at the portfolio constituents will tell you a lot about how much importance they attach to their ESG research findings.

For more information about our Responsible Investment Service, contact Chris Redman on 0203 750 1810.

Chris Redman, Chartered FCSI, Investment Director and Head of ESG Investments