Waving Banners – Have Some ESG Managers Lost Their Way?
Research Roundtable Publication
Our Talk With Meir Statman
We have been helping investors make socially responsible investments for almost 20 years (at FWP and in senior roles at prior firms) and we support clients who want to express their Environmental, Social, and Governance principles (ESG) in portfolios.
The passion for this type of investing has always been high and record amounts of assets are now flowing into ESG investment funds.
To try to provide investors with more insights in this area of investing, we reached out to Meir Statman, the Glenn Klimek Professor of Finance at Santa Clara University.
For those who don’t know Professor Statman, he is an early pioneer in ESG investment research. His papers have been published by many leading investment journals such as the Journal of Finance, the Journal of Financial Economics and the Journal of Portfolio Management. In addition, the research has been supported by the National Science Foundation, the CFA Institute Research Foundation, and the Investment Management Consultants Association (IMCA).
Statman is a recipient of a Batterymarch Fellowship, a William F. Sharpe Best Paper Award, two Bernstein Fabozzi/Jacobs Levy Awards, a Davis Ethics Award, a Moskowitz Prize for best paper on socially responsible investing, a Matthew R. McArthur Industry Pioneer Award, three Baker IMCA Journal Awards, and three Graham and Dodd Awards.
The title of this post comes from the following quote from a recent paper Statman wrote for the Journal of Portfolio Management, ESG as Waving Banners and as Pulling Plows.
“The ESG movement lost its way…”
The following are excerpts from our talk.
Research Roundtable:
Professor Statman, thank you for spending time with us.
How did you become interested in ESG and what have you seen evolve in the space over the years?
Statman:
I became interested in ESG, or SRI, as it was called, in the early-mid 1980s, because it complemented my interest and work in behavioral finance.
In standard finance, investment considerations are limited to returns and risk. The benefits and costs of ESG are not easily classified as returns or risk, and yet some people are very passionate about ESG, beyond returns and risk.
In behavioral finance, I describe investors who choose investments by the utilitarian benefits and costs of returns and risk, but also by the expressive and emotional benefits and costs of staying true to their values and improving the world.
At the time, almost no one in academia was looking at ESG. The first paper that I wrote about it with colleagues was published in 1993. I continued on from there.
The field has become very popular in the last decade, and much of the focus is now on whether ESG returns are higher or lower than the returns of conventional alternatives. This focus on utilitarian benefits and costs is natural in finance, yet it misses the heart of ESG, which is in expressive and emotional benefits.
This underlies my notion that the ESG movement may have lost its heart, its good way, and my desire to see it return to its good way.
Research Roundtable:
What do you think is the biggest change in the industry that you’ve seen over the past 30 years?
Statman:
One thing that sticks in my mind is a Socially Responsible Investing (SRI) in the Rockies conference I was invited to speak at in the 1990s. It is now simply called the SRI Conference.
The number of people that were interested in ESG investing at the time was very small but they were very passionate about it.
I remember that I said something a bit self-righteous about ESG investors caring too much about returns. Afterwards, I was called out when an adviser reminded me that socially responsible investors have to retire someday, too.
The ESG movement of the time did not ignore returns and risk, but it was more focused on staying true to values and improving the world.
Now, however, many investors seem to focus entirely on returns and risk. To some, ESG is now a factor, like small, value, or momentum.
Research Roundtable:
What has your research revealed about this shift?
Statman:
ESG returns are higher than conventional returns during some periods and are lower in others.
In general, ESG funds are growth oriented, so they did well in the dot-com era of the late 1990s and poorly after the crash.
Research Roundtable:
In your most recent paper, you speak about portfolio managers who are “waving flags.”
Can you describe that in your own words?
Statman:
Religious persons who refrain from eating pork are not trying to improve the world – they want to stay true to their values. They are not self-righteous about it. They do not wave banners and I respect their adherence to their values.
Many of today’s ESG portfolio managers, however, seem to be waving banners. They say that they are divesting stocks of fossil fuel companies and pulling plows to improve the world. In truth, however, managers who divest fossil fuel stocks merely sell them to other investors.
If I were an advisor working to help clients navigate ESG investment offerings, I would ask this:
Do you care about having no stocks of fossil fuel companies in your portfolio in the same way that a religious person cares about not eating pork?
If the answer is yes, you should help them build a portfolio that excludes stocks of fossil fuel companies.
You need to say, though, that it will likely cost more in lower returns, as religious persons know that Kosher beef costs more than pork.
At a minimum, ESG portfolios are more costly than conventional portfolios because those who construct them must pay companies that provide ESG ratings. This is one reason ESG funds charge higher fees than conventional index funds.
If clients say that they don’t want to pay higher fees and get lower returns, maybe they should pause and consider making impacts in other more direct ways.
It is really important to have that kind of conversation with clients to find out precisely what they have in mind.
Research Roundtable:
Do you think that some ESG product presentations avoid this conversation?
Statman:
I think so and it is a shame.
I think that a conversation between an adviser and a client about wants, values, and the facts of finance is really important and goes well beyond ESG.
Research Roundtable:
We agree and think that it is the responsibility of an adviser to have these conversations with clients.
What are your views on the ESG fund presentations that promote no tradeoffs – higher returns and high social impact with lower risks?
Statman:
Let’s just be plain honest.
When investing in ESG funds, investors need to keep expectations low in terms of returns.
If you’re lucky you are not going to lose anything in returns, as compared to the market or index funds.
Based on this, you then need to ask if this is something an investor is still interested in.
Research Roundtable:
What do you think about the quality of ESG databases and ratings?
Statman:
ESG ratings of each company vary enormously by the company rating it.
It is important that you understand what you are after and figure out which ones are right for you.
In many ways ESG ratings are in the eye of the beholder and some ratings are enormously expensive.
As an investor you have to ask this:
Are you willing to spend that kind of money for return benefits that might not be there?
Research Roundtable:
ESG seems like a form of active management.
If the data suggests that it is very difficult for most other forms of active management to outperform a broad based low cost index fund, net of all fees, taxes, and other costs, such as manager analysis, search, and selection, how is it that an ESG form of active management is any different?
If an investor wants to invest in a certain way to express values, as advisors we should help them.
It seems like a lot of what you call “banner waving” is happening, though, suggesting to investors that this new form of ESG active management will be different and will allow investors to achieve what some call triple wins (higher positive social impact, higher returns, and lower risk).
Statman:
Absolutely.
Precisely what I say.
Advisers should say that ESG portfolios cost more and clients bear the extra costs.
The extra costs of an ESG portfolio may swamp any extra ESG returns. ESG investors should keep alpha hopes very low.
Research Roundtable:
Claims of ESG outperformance, alpha, and excess returns are often front and center in presentations, though. What are you thoughts about this and the issues for investors to consider?
Statman:
ESG outperformance, alpha, and excess returns should not be at the center of the discussion.
At the center should be clients’ aspirations and goals and advisers’ help in achieving them.
If clients say that investing by ESG principles is right for them and they understand the extra ESG costs, advisers can guide them to ESG investments.
If clients say, I heard about these magic do-good, high-return pills, however, an adviser should say:
Do good – maybe.
High returns – probably not.
More advisors should simply share what the findings of multiple independent research studies show.
If investors want higher than index returns, they should try to find investments that are not available to others and that have real prospects for extra returns. Unfortunately, this is something that the vast majority of investors (professionals included) have not be able to do.
I understand, however, that my life as an academic is easier than the life of an adviser.
I work hard to teach each and every student. Yet I’m paid by the university even if a student did not like my teaching.
But, the investment business is not like academia.
Research Roundtable:
For what it’s worth, we are always saying that shame on us if we are enablers.
We hope that clients pay us for opinions and we ought to share our thoughts, even when we know that they might not agree.
As long as someone is paying us, we should try to be as transparent as possible about the pros, cons, and probabilities, and let the chips fall where they may.
Statman:
You are absolutely right.
Your values are like mine.
Research Roundtable:
How about the risk side of ESG?
We’ve been talking about returns but many say that ESG funds have lower risk profiles than broad based index funds.
Statman:
Perhaps, but ESG is not the best way to reduce risk.
Moreover, risk is not in the volatility of your portfolio. Risk is in failure to reach your aspirations or goals.
You do well by your clients by helping them reach their aspirations or goals.
Research Roundtable:
Back to where we started…
Has ESG lost its way?
Statman:
In my most recent paper, I say this:
ESG managers who do no more than exclude stocks of fossil fuel producers from their portfolios are banner-minded ESG investors.
Banner-minded managers want to do well but expect to earn market returns, if not higher. They might want to stay true to their values, but they are unwilling to sacrifice any portion of their utilitarian returns for these benefits. More importantly, they do no good, doing nothing to enhance the utilitarian, expressive, and emotional benefits of others.
ESG managers who invest in housing for the homeless, are plow-minded ESG investors. They want to do good and are willing to accept lower than market returns. Plow-minded ESG managers want the expressive and emotional benefits of staying true to their values and are willing to sacrifice portions of their utilitarian returns for these benefits. More importantly, they do much good, enhancing the utilitarian, expressive, and emotional benefits of others.
In the last few decades, many ESG managers seem to have lost their way – transitioning from doing good to doing well, and from plow-minded investors to banner-minded and pseudo-ESG managers.
That transition expanded the ESG movement by adding investors but degraded it from doing good to doing well.
It is time for the movement to regain its way, transitioning back from doing well to doing good, from banner-minded and pseudo-ESG managers to plow-minded investors, and from wants for utilitarian returns for oneself to wants for utilitarian, expressive, and emotional benefits for others.
Research Roundtable:
Thank you, Meir. We really appreciate your time.
Statman:
Thank you for the opportunity to speak with you.
I hope that I’ve been helpful.
Related Reading:
ESG as Waving Banners and as Pulling Plows – Journal of Portfolio Management – Meir Statman
You Want to Invest Responsibly – Wall Street Journal – Jason Zweig
ESG – Love the Market But Question The Pitch? – Sloan Ortel
An Economic Framework for ESG Investing – Academic Insights – Elisabetta Basilico
Investing in Ethical Funds – MoneyWeek – Robin Powell
Beware of Sharpe Objects 
The Certain Drag on Performance – Taxes 