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A term that went from euphoria to criticism. That has been the parabolic path of sustainable investing in recent years. Now, investors wonder what’s in store for environmental, social and governance (ESG) investing in 2023, and more importantly, what the threats to ESG might be.
“Sustainable investing and the consideration of ESG factors have become part of the investment mainstream over the past few years. The rapid growth has been spurred by the need for investors to consider nonfinancial risks posed by problems ranging from climate change to natural resource depletion, treatment of workers throughout the supply chain, corporate ethics, and wealth inequality,” says Jon Hale, Director of Sustainability research for the Americas at Morningstar Sustainalytics.
“We live in an age of transparency, and stakeholders are demanding better corporate accountability around these types of issues. More end investors want their investments to make a difference,” he adds.
Sustainable investing is in the mainstream now, but it came under attack in 2022. Morningstar experts identified five main threats to ESG in 2023, that could be of interest to Canadian investors.
Let’s look at each of these in some detail.
In the U.S., sustainable investing has unleashed a hurricane of criticism, with accusations ranging from deceptiveness and ineffectiveness to a secret agenda to impose “woke” values on capitalism and society.
“ESG could face new challenges in the U.S. beginning Jan. 3, when the Republican Party takes control of the U.S. Congress. That could bring hearings or other attempts to discredit ESG, including, for example, one proposed law, introduced in the Senate, to protect farmers from the SEC’s forthcoming climate disclosure rules.”, says Leslie Norton, Editorial Director for Sustainability at Morningstar.
“ESG has been in the crosshairs of the Republican Party all year, with the loudest critics comprising some aspiring presidential candidates, including Florida Governor, Ron DeSantis. Indeed, Florida recently said it will pull USD 2 billion of assets managed by BlackRock (BLK), which it accused of having goals other than pursuing returns. BlackRock, in turn, condemned ‘political initiatives like this that sacrifice access to high-quality investments and thereby jeopardize returns, which will ultimately hurt Florida’s citizens.’ Other Republican-controlled states have already withdrawn money from BlackRock,” adds Norton.
What happens next? “My personal view is there will be a lot of noise, very little action,” says David Sand, chief impact strategist at Community Capital Management. “I can’t imagine legislative interference in portfolio management decisions.”
“Indeed, we’d argue that ESG and sustainable investing aren’t going anywhere, because it offers a fuller view of risk and opportunity. Just look across the Atlantic, where sustainable investing is firmly entrenched,” concludes Norton.
Adam Fleck, Director of ESG Equity Research at Morningstar, thinks that scrutiny and discussion are necessary and positive to drive the maturation and growth of the industry, but he says that “the consideration of financially material ESG risks and opportunities is a critical part of valuing a company’s stock.”
“That’s true no matter which way the winds of political sentiment or market performance are blowing. But importantly, this ESG integration differs from a consideration of ESG impact, in which different investors will express their varied preferences through personal choices in their portfolios”.
“Conflating the two – risk and impact – can be disingenuous and dangerous. Investors who believe that the use of ESG risk integration should be expected to drive positive societal impact are bound to be disappointed, while critics who point to differing preferences among impact outcomes as an excuse to ignore ESG risk integration does so at their own peril.”
This year, COP27, the U.N. climate summit in Sharm-El-Sheikh, disappointed ESG supporters. Except for a commitment for a new fund to help poor countries manage climate-related damage, there was little to celebrate. For example, there was no commitment on any ambitious targets such as phasing out all fossil fuels and having global emissions peak by 2025.
Moreover, it seems that in the investment industry something is creaking in the commitment to fight climate change and the adoption of sustainable practices, as a consequence (also) of the war in Ukraine and attempts to politicize ESG issues.
In recent months, the energy crisis has increased the demand for fossil fuels and some countries have responded with an increase in the use of oil, gas and coal. The priority of many governments has become that of energy security.
What will happen at COP28 that will take place in the petrostate of United Arab Emirates in 2023? Will the fossil fuel lobbies raise their voices? Experts said that more progress is needed to attain 2012 Paris Agreement’s targets, but after COP26, actions to quickly reduce the impacts of climate change have stalled.
“When it comes to the future of energy, we need to be emitting much less carbon than we are today. For this to occur, investment in cleaner fuel sources will need to ramp up materially over the next few years, as things stand today we are simply not denting the trajectory of carbon emissions, which continues its upward trend almost unabated”, said Michael Field, European Market Strategist at Morningstar.
When German authorities raided Deutsche Bank and its asset manager DWS in May 2022, greenwashing quickly went from just being bad marketing practices to being a massive legal risk. Much criticism has arisen around greenwashing, a practice in which fund managers (and companies) are accused of misleading customers by exaggerating the sustainability attributes of their products.
Regulators in many countries are trying to address this issue and something could change in 2023.
“Navigating the ESG and sustainable fund market will remain a challenge in 2023 as greenwashing accusations intensify. Regulators are determined to clamp down on misleading ESG claims to protect end investors. This is of course necessary in order to restore trust as there is a lot of cynicism right now about ESG products,” says Hortense Bioy, Global Head of Sustainability Research at Morningstar.
Establishing a common ground for ESG disclosure remains a challenge in 2023 and beyond.
“When it comes to ESG product disclosures, the most advanced regime remains the EU’s Sustainable Finance Disclosure Regime, or SFDR, a key component of the wider EU Action Plan. This is straightforward for products domiciled or invested within Europe, but those outside of the EU are not bound by the same restrictions, making direct comparison almost impossible. These difficulties are likely to compound further as more countries develop their own taxonomies and classification frameworks, each with a unique set of requirements and deadlines,” said Andy Pettit, director of Policy research at Morningstar EMEA.
“Investment product disclosures have varied considerably from market to market long before the incorporation of ESG issues, but they did, however, benefit from a standardized way of calculating key information points. Things like past performance and expense ratios have remained consistent, which is invaluable for common understanding and comparability.”
“If this same international agreement was applied to key sustainability metrics and their calculation, it would matter less which type of document was used to present this information to investors – an SFDR-type disclosure, a UK consumer-friendly disclosure, or any other.”
ESG fund performance may continue to be challenged by the macro-environment and the current energy crisis.
“In 2022, ESG fund performance suffered from high fossil fuel prices as ESG funds tend to be underweighted in traditional energy companies, while they overweigh the technology sector,” explains Bioy.
“Investors should be constantly reminded that all investments can go through periods of underperformance. ESG and sustainable strategies are no different. But investors should focus on the long term. Sustainability is about the long term.”
You might not think it’s possible to outperform the average Wall Street professional with just a single investment. Fund managers are highly educated and steeped in market data. They get paid a lot of money to make smart investments.
But the truth is, most of them may not be worth the money. With the right steps, individual investors can outperform the majority of active large-cap mutual fund managers over the long run. You don’t need a doctorate or MBA, and you certainly don’t need to follow the everyday goings-on in the stock market. You just need to buy a single investment and hold it forever.
That’s because 88% of active large-cap fund managers have underperformed the S&P 500 index over the last 15 years thru Dec. 31, 2023, according to S&P Global’s most recent SPIVA (S&P Indices Versus Active) scorecard. So if you buy a simple S&P 500 index fund like the Vanguard S&P 500 ETF (NYSEMKT: VOO), chances are that your investment will outperform the average active mutual fund in the long run.
It’s a good bet that the average fund manager is hardworking and well-trained. But there are at least two big factors working against active fund managers.
The first is that institutional investors make up roughly 80% of all trading in the U.S. stock market — far higher than it was years ago when retail investors dominated the market. That means a professional investor is mostly trading shares with another manager who is also very knowledgeable, making it much harder to gain an edge and outperform the benchmark index.
The more basic problem, though, is that fund managers don’t just need to outperform their benchmark index. They need to beat the index by a wide enough margin to justify the fees they charge. And that reduces the odds that any given large-cap fund manager will be able to outperform an S&P 500 index fund by a significant amount.
The SPIVA scorecard found that just 40% of large-cap fund managers outperformed the S&P 500 in 2023 once you factor in fees. So if the odds of outperforming fall to 40-60 for a single year, you can see how the odds of beating the index consistently over the long run could go way down.
Warren Buffett is one of the smartest investors around, and he can’t think of a single better investment than an S&P 500 index fund. He recommends it even above his own company, Berkshire Hathaway.
In his 2016 letter to shareholders, Buffett shared a rough calculation that the search for superior investment advice had cost investors, in aggregate, $100 billion over the previous decade relative to investing in a simple index fund.
Even Berkshire Hathaway holds two small positions in S&P 500 index funds. You’ll find shares of the Vanguard S&P 500 ETF and the SPDR S&P 500 ETF Trust (NYSEMKT: SPY) in Berkshire’s quarterly disclosures. Both are great options for index investors, offering low expense ratios and low tracking errors (a measure of how closely an ETF price follows the underlying index). There are plenty of other solid index funds you could buy, but either of the above is an excellent option as a starting point.
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The numbers from the Department of Finance suggest they have struck taxation gold. But they’ve been wrong before
Published Apr 19, 2024 • Last updated 8 hours ago • 5 minute read
“99.87 per cent of Canadians will not pay a cent more,” the prime minister said this week, in reference to the budget announcement that his government will raise the inclusion rate on capital gains tax in June.
The move will be limited to 40,000 wealthy taxpayers. “We’re going to make them pay a little bit more,” Justin Trudeau said.
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But it’s hard to see how that number can be true when the budget document also says 307,000 corporations will also be caught in the dragnet that raises the inclusion rate on capital gains to 66 per cent from 50 per cent.
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Many of those corporations are holding companies set up by professionals and small-business owners who are relying on their portfolios for their retirement.
The budget offers the example of the nurse earning $70,000 who faces a combined federal-provincial marginal rate of 29.7 per cent on his or her income. “In comparison, a wealthy individual in Ontario with $1 million in income would face a marginal rate of 26.86 per cent on their capital gain,” it says.
Policy wonks argue that the change improves the efficiency and equity of the tax system, meaning capital gains are now taxed at a similar level to dividends, interest and paid income. The Department of Finance is an enthusiastic supporter of this view, which should have set alarm bells ringing on the political side.
That’s not to say it’s not a valid argument. But against it you could put forward the counterpoint that capital gains tax is a form of double taxation, the income having already been taxed at the individual and corporate level, which explains why the inclusion rate is not 100 per cent.
The prospect of capital gains is an incentive to invest particularly for people who, unlike wage earners, usually do not have pensions or other employment benefits.
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That was recognized by Bill Morneau, Trudeau’s former finance minister, who said increasing the capital gains rate was proposed when he was in politics but he resisted the proposal.
Morneau criticized the new tax hike as “a disincentive for investment … I don’t think there’s any way to sugar-coat it.”
Regardless of the high-minded policy explanations that are advanced about neutrality in the tax system, it is clear that the impetus for the tax increase was the need to raise revenues by a government with a spending addiction, and to engage in wedge politics for one with a popularity problem.
The most pressing question right now is: how many people are affected — or, just as importantly, think they might be affected?
One recent Leger poll said 78 per cent of Canadians would support a new tax on people with wealth over $10 million.
But what about those regular folks who stand to make a once-in-a-lifetime windfall by selling the family cottage? We will need to wait a few weeks before it becomes clear how many people feel they might be affected.
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The numbers supplied to Trudeau by the Department of Finance suggest they have struck taxation gold: plucking the largest amount of feathers ($21.9 billion in new revenues over five years) with the least amount of hissing (impacting just 0.13 per cent of taxpayers).
The worry for Trudeau and Finance Minister Chrystia Freeland is that Finance has been wrong before.
Political veterans recall former Conservative finance minister Jim Flaherty’s volte face in 2007, when he was forced to drop a proposal to cancel the ability of Canadian companies to deduct the interest costs on money they borrowed to expand abroad.
“Tax officials vastly underestimated the number of taxpayers affected when it came to corporations,” said one person who was there, pointing out that such miscalculations tend to happen when Finance has been pushing a particular policy for years.
Trudeau’s government has some experience of this phenomenon, having been obliged to reverse itself after introducing a range of measures in 2017, aimed at dissuading professionals from incorporating in order to pay less tax. It was a defensible public policy objective but the blowback from small-business owners and professionals who felt they were unfairly being labelled tax cheats precipitated an ignoble retreat.
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Speaking after the budget was delivered, Freeland was unperturbed about the prospect of blowback. “No one likes to pay more tax, even — or perhaps more particularly — those who can afford it the most,” she said.
She’d best hope such sanguinity is justified: failure to raise the promised sums will blow a hole in her budget and cut loose her fiscal anchors of declining deficits and a tumbling debt-to-GDP ratio.
That probably won’t be apparent for a year or so: the government projected that $6.9 billion in capital gains revenue will be recorded this fiscal year, largely because the implementation date has been delayed until the end of June. We are likely to see a flood of transactions before then, so that investors can sell before the inclusion rate goes up.
After that, you can imagine asset sales will be minimized, particularly if the Conservatives promise to lower the rate again (though on that front, it was noticeable that during question period this week, not one Conservative raised the new $21 billion tax hike).
The calculated nature of the timing is in line with the surreptitious nature of the narrative: presenting a blatant revenue grab as a principled fight for “fairness.” The move has the added attraction of inflicting pain on the highest earners, a desirable end in itself for an ultra-progressive government that views wealth creation as a wrong that should be punished.
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Trudeau’s biggest problem is that not many voters still associate him with principles, particularly after he sold out his own climate policy with the home heating oil exemption.
The tax hike smacks of a shift inspired by polling that indicates that Canadians prefer that any new taxes only affect the people richer than them.
Success or failure may depend on the number of unaffected Canadians being close to the 99.87-per-cent number supplied by the Finance Department.
History suggests that may be a shaky foundation on which to build a budget.
National Post
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