After doing little during the early years of the ESG bonanza, regulators are trying to catch up. Just last month, the U.S. Securities and Exchange Commission proposed a slate of new restrictions aimed at ensuring ESG funds accurately describe their investments. Some also would need to disclose the aggregated greenhouse gas emissions of companies in which they're invested, according to the SEC.
Mr. Dodson, who used to run Parnassus Investments and has described the ESG market boom as "disconcerting,'' called for the creation of a group modeled on Wall Street watchdog Financial Industry Regulatory Authority. It should be a non-profit organization backed by the government that charges fees, conducts audits and exams, and has enforcement powers, he said.
The end result would be more firms getting kicked out of the business for failing to adhere to the highest investing and marketing standards, said Mr. Dodson, who retired last year from Parnassus, which he founded in 1984. The firm now manages $47 billion.
When the ESG investment strategy was conceived in the mid-2000s, its intention was to help investors measure risks and opportunities from environmental, social and corporate governance-related issues. It's now morphed into myriad investment strategies ranging from mutual funds to complex derivatives designed by Wall Street banks.
For Ms. Pinilla, director of sustainable investing at Zevin Asset Management, the criticisms are welcome because they shine a spotlight on widening concerns about industry practices, especially among newer entrants. This rethink will help separate "the wheat from the chaff," she said. "We need to be examined. It will help people get more precise about what exactly they're doing.''
Ms. Pinilla said ESG needs to be "decentralized" so those making claims specifically spell out their analysis of risks associated with "the E, the S and the G." For example, investors would analyze workplace diversity as a separate topic from greenhouse gas emissions and corporate governance rather than lumping their analysis together, she said.
"While they intersect, they need to be understood individually, not neatly bundled together," she said.
It's an approach that would make it harder for fund managers to claim that Tesla Inc., for example, lives up to the ESG label. While the electric-vehicle maker meets the standards of an environmentally friendly stock, its track record on social and governance issues raises a lot of awkward questions.
Early signs have emerged that investors are souring on the process. They pulled a record net $2 billion from U.S. equity exchange-traded funds in May, ending three years of inflows, according to Bloomberg Intelligence. The redemptions are early signs of investors' concerns about ESG as global financial markets are rattled by inflation and the ongoing war in Ukraine.
Mr. Kiernan, whose scores became the foundation for those sold today by MSCI, the world's biggest provider of ESG ratings, said the industry needs to double its efforts to fix the ratings system because they're inconsistent and too many money managers use them to decide what stocks to buy. Additionally, industry groups need to raise their standards to winnow out fund managers who aren't following through on their commitments to the strategy, while institutional investors need to be more discerning about which managers they give their money to so money flows to only those who are doing bona fide sustainable investing, he said.
If these three steps are taken, the amount of money invested in so-called sustainable funds would drop in half from the $2.7 trillion now estimated by Morningstar, Mr. Kiernan said. While there will be "a rather awkward transition," it will ultimately result in genuine ESG funds "standing out and attracting more capital," he said.
"Self-designated ESG investors, especially those running somebody else's money, need to raise their games," he said. "Big time."
