Below the Surface of ESG Funds | Chief Investment Officer

More than 1,000 US equity funds have virtually no exposure to fossil fuels despite not being marketed as ‘green’ or environmental, social, and governance (ESG) investments, according to research from MSCI.

“Transparency serves as a tool for creating a wider pool of options where product availability may be a limitation.”Across asset classes, roughly 15% of the 21,000 mutual and exchange-traded funds analyzed by MSCI had a significant tilt towards ESG factors. This included a small number of thematic funds (roughly 2% of the sample), but the majority emphasized themes such as alternative energy, health care, and nutrition without being specifically built as ESG or responsible investment products.

The data comes from MSCI’s ESG Fund Metrics tool, launched to provide investors with ESG risk scores and detailed information on the equity, bond, and multi-asset funds it monitors.

The data also revealed that more than 6,900 equity funds—nearly half of those analyzed by MSCI—had exposure to companies that manufacture controversial weapons such as cluster bombs and land mines. Such companies feature regularly on the banned stock lists for major asset owners in Europe and the US.

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“A deficit of objective measurements of the ESG characteristics of fund holdings leaves investors facing several important gaps,” wrote MSCI analysts Laura Nishikawa, Matt Moscardi, and Ken Frankel in the research group’s report, “Fund Transparency: Exploring the ESG Quality of Fund Holdings.”

Investors have “limited visibility” on fund holdings in order to evaluate how ESG strategies translate into practice, the authors said. In addition, investors may find their options limited by this lack of transparency.

“Transparency also serves as a tool for creating a wider pool of options where product availability may be a limitation or as a differentiator for investors,” Nishikawa, Moscardi, and Frankel wrote.

The research paper is available for download from MSCI’s website (registration required).

Short-term institutional investors advocate firm behaviors that are harmful to long-term shareholders, research has shown.

These short-term investors pressure firms to spend less on research and development (R&D), generating earnings surprises that lead to temporarily inflated stock prices, according to the University of Notre Dame Professor Martin Cremers, Rutgers University Assistant Professor Ankur Pareek, and Professor Zacharias Sautner of the Frankfurt School of Finance and Management.

“Short-term investors may pressure executives to reduce R&D to surprise the market with higher earnings, and markets may not be able to immediately determine that these R&D reductions are detrimental to long-term firm value,” they wrote.

By measuring the stock holding duration of institutional investors, Cremers, Pareek, and Sautner showed that under the influence of short-term investors, firms spent less on R&D—investments “whose benefits are likely manifested on in the long-run, while their expenditures depress current earnings.”

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As R&D spending is expensed directly on firm income statements, reductions in long-term investments allowed firms to report higher earnings—and in turn boost stock prices in the short term, as investors “misinterpret the positive earnings surprises.”

“As short-term investors move en masse into particular stocks, their equity market valuations increase substantially relative to fundamentals—but only temporarily,” the researchers wrote.

When short-term investors exit a firm, these artificial gains are erased as R&D spending starts up again.

“Short-term investors benefit from temporarily inflated valuations, as their short horizons ensure that they exit the firm shortly afterwards,” Cremeres, Pareek, and Sautner concluede. “As a result, only long-term shareholders eventually suffer from the reduction in investment.”

Read the full report, “Short-Term Investors, Long-Term Investments, and Firm Value.”