Research Roundtable Publication
In the investment world, commentators and asset managers are quick to suggest that many clear benefits exist when investing in ESG funds.
They speak of investment vehicles that produce significant win-win outcomes: meaningful environmental and social progress alongside improved investment returns and reduced risk.
Is this for real?
I’d love to say yes.
Heck, I would love to be among the biggest promoters of these strategies. But it’s tough, because morality and the money management industry make for uneasy bedfellows.
It happens to be Pride Month as I write this, so there’s a clear corollary staring me in the face.
Every year companies put little rainbow flags on their products, crank out t-shirts touting their commitment to human rights, and then seem to forget after the parades quiet down.
I guess it’s good that companies are marketing to LGBTQIA folks instead of ignoring or caricaturing us, but they tend to avoid doing much that actually helps the community, ignore opportunities to address issues related to race, class, and gender, and shy away from taking meaningful action to protect the communities.
Is the better part of wisdom to question whether it is a more straightforward attempt to maximize profits? There’s nothing wrong with that. But it gets messy when firms wrap such efforts in moral philosophy.
And that’s the thing about ESG funds.
Is there a central sleight of hand where we are invited to forget that we’re considering pooled investment vehicles with material expenses, which may in the end simply track or underperform broad based indices net of all fees?
Is this a new thing?
The social norm of responsible ownership is at least as old as the written word. Early legal codes like the Sumerian Code of Urukagina reliably impelled citizens to mend their fences in order to prevent harm to neighbors, prevent their oxen from running amok, and otherwise make sure they managed their property in a way that was conscious of their community’s needs.
Religious groups have also long pushed their members to integrate their beliefs and their commercial practices.
Faith-based reasoning was also behind one of the earliest organized divestments on record, when Quakers explicitly forbade their members from profiting from the slave trade in 1758. They later furthered their commitments in 1898 by forming the Quaker Friends Fiduciary corporation and excluding alcohol, tobacco, and firearms from its investment portfolios.
The same fundamental logic – excluding objectionable investments from portfolios – also characterized the early modern growth of responsible investing.
Student and activist groups began to pressure institutional investors to divest from the apartheid state of South Africa in the 1960s. And in 1977, after the Rev. Leon Sullivan codified what he deemed to be appropriate corporate behavior, what came to be known as the Sullivan Principles achieved some significant successes – liberating Nelson Mandela and inspiring former president Barack Obama to make his first political speech are among just a few.
The movement continues to produce some positive social outcomes but what investment results has it produced?
Promising foundations with investor caveats.
One thing is for sure, the asset growth of ESG investment funds has been strong.
2020 saw the launch of 71 sustainable investing funds and a record $51.1 billion in net investment flows into the category according to Morningstar. Both of these figures are all-time records, which implies that the investing public is in a moment of pitched interest in these strategies. And that’s just listed investment funds available to American investors.
It’s easy enough to see why these strategies are popular.
First, it is intuitive to think that companies who have more socially conscious governance and accountability structures in place may be leaders on issues like the environment, equity, diversity, human rights, animal welfare, and consumer protection.
The data on company financial performance is also encouraging.
A recent meta-analysis of 1,272 company specific ESG studies, which was conducted by researchers working with the New York University (NYU) Stern Center for Sustainable Business, found this:
“Consistent positive correlations between ESG and corporate financial performance.”
This is all compelling for sure, but from an ESG fund investor standpoint, the studies don’t tend to take into account implementation issues (it’s hard to construct a portfolio of the best stocks at the correct time) and the costs of managing investment funds (fees for the extra research and portfolio construction can add up).
Along these lines, the same NYU Stern Center paper stated the following related to a meta-analysis of over 100 investor studies:
“ESG investing returns were generally indistinguishable from conventional investing returns.”
Another issue to consider is that no reliable measure of a company’s “true” ESG performance seems to exist. Instead, there are various rating systems that have material differences from each other.
As an example, a recent working paper from MIT Sloan found only moderate correlations (averaging .54 and ranging from .38 to .71) between the ratings produced by six leading ESG rating agencies.
In other words, there’s enough nuance in the numbers that one can’t simply rely on an ESG label.
The question might be this:
Is it really social transformation?
Unfortunately, a few voices close to the actual manufacturing of ESG funds suggest not.
One of the most prominent examples is Tariq Fancy, who is Blackrock’s former Chief Investment Officer for sustainable strategies. In a recent CNBC appearance, he put it succinctly:
“Imagine the planet is a cancer patient, and climate change is the cancer. Wall Street is prescribing wheatgrass: a well-marketed profitable idea that has no chance of curing or even slowing down the cancer. In this scenario, wheatgrass is a deadly distraction, misleading the public and delaying life-saving measures like chemotherapy.
The more you give people messaging around a whole bunch of things around social purpose, that businesses will do the right thing all by themselves voluntarily… the more you mislead the public into thinking that free markets will correct themselves, and that we don’t need government regulation. This comes directly at the expense of the youngest and the poorest in society.”
In other words, he’s saying it might be a crutch.
More confusing claims?
Perplexingly, many of the new funds that are being released look an awful lot like old funds with a new name and (typically) higher fees.
Over at the Wall Street Journal, Jason Zweig discussed the launch of Blackrock’s US Carbon Transition Readiness fund with an exploration of how the fund differs from its siblings in a piece titled, You Want to Invest Responsibly? – Wall Street Smells Opportunity.
“The Carbon Transition fund’s top five companies, totaling 19.5% of total assets, are Apple, Microsoft, Amazon, Facebook, and Google’s parent, Alphabet. After a fee waiver, the fund charges 0.15% in annual expenses.
A sibling fund, iShares Core S&P 500 ETF, holds the identical top five companies, in slightly different order and at 21.5% of total assets, for an annual expense of only 0.03%.
So the Carbon Transition fund looks a lot like a carbon copy of a broad-market index, but with higher fees.”
Remember Mr. Fancy’s worry that the way ESG strategies are marketed misleads the public into thinking that something is being done about pressing global challenges like climate change? That could be very real.
Love the market, hate the markup
Even though ESG funds may produce alpha net of all fees, the jury is still out on this. A few voices say not.
It is also important to consider whether or not entrusting some of these funds with dollars actually results in the advances in the environmental, social, and governance issues that you desire.
None of this is to say the whole thing is a waste of time or that ESG investing is bad.
Pressure from the investment community has likely pushed public companies to take stakeholder groups seriously.
That is unequivocally good.
In addition, disclosures of how companies are implementing ESG principles can positively impact an investor’s decisions and positively impact society.
And because there isn’t a broad consensus about how to digest it, inefficiencies may exist, which could provide managers with an ability to add bottom-line value by using it distinctively.
But the benefits don’t accrue automatically.
It’s crucial that investors who are interested in making a difference understand that aligning their portfolio with their social and environmental beliefs can involve extra portfolio management costs, which may reduce performance.
In light of this, might the extra dollars spent on portfolio management services or manager search activities have more impact if they were spent on supporting effective charities and community organizations?
That is for each investor to decide.
ESG funds are products that are sold with a mark-up just like any others.
Before investing in an ESG fund, ask a lot of questions and evaluate all options.
If not, beware.…
Instead of making positive contributions to important ESG causes, you may only end up being a patron of asset management companies.
ESG and Financial Performance – NYU Stern Center for Sustainable Business
Aggregate Confusion: The Divergence of ESG Ratings – MIT Working Paper
Sustainable Funds U.S. Landscape Report – Morningstar
Four Things No One Will Tell You About ESG Data – Journal of Applied Corporate Finance
You Want to Invest Responsibly? – Wall Street Smells Opportunity – Wall Street Journal
Doing Well While Doing Good? – The Investment Performance of Socially Responsible Mutual Funds – Hamilton, Jo, and Statman – CFA Institute