Even if it didn't underperform, ESG investing would be a moral mess. Environmental, Social, and Governance (ESG) are the three hottest words in the investment industry today. How hot? Bloomberg says “ESG assets may hit $53 trillion by 2025, a third of global AUM (assets under management).”
The conceit of ESG is simple. Mix environmental hygiene, social justice, and virtuous governance; shake; and pour. Behold, the perfect portfolio. Feel good while getting rich. Finally, one can align his values with his investments. A good and honorable IRA.
You might recognize ESG as a marketing refresh of SRI — Socially Responsible Investing, which gained limited popularity in the 1990s. Same idea, new name.
So, how does ESG perform as an investment?
The simplest measure, the S&P 500 versus Large Cap Blend funds (the category for the S&P 500), shows that 60 percent of the time the average Large Cap Blend fund beat the average Morningstar High Sustainability rating (a measure of ESG) fund of the same type in the last ten years (2011-2020). On average, ESG was a loser.
Morningstar Inc. says its own ESG indexes outperformed in 2020. Others — NYU finance professor Aswath Damodaran in a recent piece called “Sounding good or Doing good? A Skeptical Look at ESG,” and the Journal of Business Finance & Accounting — say ESG failed during the COVID-19 crash, and if you correct for tech tilt (under the hood, ESG is simply a tech play), its returns dissolve. Overall, a report from Pacific Research Institute concludes, “ESG funds have not yet shown the ability to match the returns from simply investing in a broad-based index fund.”
However, for argument’s sake, let’s say that investment returns are neutral — that ESG performs as well as non-ESG. Under the assumption that returns won’t be affected, why not choose ESG? What is wrong, in principle, with ESG?
The answer is the same one that every Christian gets in his college dorm room when practicing apologetics on his roommate. Ultimately the dispute narrows down to values; the winning blow is always, “Whose values?” Whereupon the debate halts because at this point the Christian discovers that to the advanced mind of his roommate, all values are equivalent. Examples are many, boasts the roomie. “Some cultures revere old people. Others euthanize them.” Oh well. “Some cultures punish thieves. Others consider stolen goods communal property.” Interesting. “Some cultures hold doors for women out of respect. Others stone them for adultery.” Ouch — “but yeah, totally their right. Who am I to say it’s wrong?” Resolved. There are no universal values. No universal truths. The roomie concludes, “You see, if there is only one truth, how can the word truths even exist.”
Congratulations. We have now graduated into the post-war pedagogical ideal that all ethics is local and parochial. No more universal accepted truth. Truth itself is an anachronism — a jingoistic dominance, probably white, probably male, probably American, certainly outdated, an abomination.
Unto this void emerges ESG. ESG replaces doubt with certainty. Something we can believe in. It is that universal truth that we crave.
ESG replaces moral equivalence with certainty. Most startling about ESG promoters is that they assume we are all on board — as if their conventions are a shared truth, settled science. ESG believes we agree: Cheap, safe natural gas is bad, but expensive, inaccessible solar is good; tobacco is out, but alcohol and marijuana are in; animal testing is cruel, but human testing is fine; management is corrupt, but unions are just; CO2 emissions are forbidden, but retired toxic car batteries are allowed; farming forests is past, but mining lithium is the future; wind power is sustainable, but nuclear power is not; Dubai is investable, but Israel is not; chairman and CEO combined is bad, but splitting roles into two people is good; diversity of skin color and gender is imperative, but diversity of opinion is disruptive; nationalism is aggressive, but multinationalism is benign. Observe these rules, and you earn a high ESG rank.
The reality is that ESG is filled with contradictions and uncertainty. We find that it is not as objective as we would hope. We end in the same place as the tortured Bertrand Russell when he said: “I wanted certainty in the kind of way in which people want religious faith. I thought that certainty is more likely to be found in mathematics than elsewhere. But I discovered that many mathematical demonstrations, which my teachers expected me to accept, were full of fallacies. . . .”
Those opposed to ESG think differently. For them, ESG is to investing what bugs are to windshields. They observe that no one is getting rich off ESG except ESG promoters, consultants, money managers, compliance companies, measurers, CE providers, lawyers, and researchers.
Meanwhile, industry is hamstrung by strictures, mandates, and edicts that spring from ESG. As always with government, recommendations become mandates. (Look at the CDC for a current example.) ESG is no longer your rebellious teenage daughter’s insistence that you quit using plastic straws. It’s now your wife’s marital demand.
Ironic that a categorically anti-business concept has been so embraced by . . . business. There is no greater enemy to animal spirits than ESG, yet the appetite for it appears to be insatiable.
California Public Employees’ Retirement System (CalPERS) is leading the way in the U.S.:
CalPERS is stepping up its ESG investment program, despite evidence that funds based only on environmental, social and corporate governance strategies have tended to underperform. . . . Going beyond a narrow profit-loss focus, the wide-ranging ESG movement pushes changes in companies that can benefit the environment and society. . . .
Highlight “narrow profit-loss focus.” How quaint. Profit-loss was not narrow in the investment industry I grew up in. Profit-loss to investing is what safety-efficacy is to medicine, fairness-judiciousness is to law, and accuracy-analysis is to engineering.
Specifically, CalPERS is required to comply with state legislation (S.B. 964) directing the funds to “report on the climate-related financial risk in its investment portfolio.” Mandatory corporate reporting of ESG by 2036 indicates this problem is going to get worse before it gets better.
Another leader in the ESG movement, École des Hautes Études Commerciales du Nord (EDHEC), claims that some portfolios that deem themselves devoted to climate change direct only 12 percent of their allocations to this worthy cause. Such offenders are deemed “greenwashers.” These wretched money managers are trying to profit off the green revolution without the all-in commitment. They should be avoided, says EDHEC.
Thus, are we to disregard the principles of diversification to accept the activists’ demand that portfolios have 12 percent, 52 percent, or 112 percent of their portfolios in ESG, just so they can’t be accused of greenwash? These are the absurd conditions that non-investment professionals are placing on investment portfolios.
So, is governance bad? Certainly not. The governance we practiced as an industry before ESG was and is superior to ESG governance. We embrace thorough due diligence, skilled oversight, reasonable regulations, etc. Specifically, the rules and regulations around managing ’40 Act funds (what I do) are critical: diversification requirements, guards against style drift, concentration requirements, fiduciary duties, and more — all absolutely necessary for shareholder value and returns.
ESG is none of that. ESG is the antithesis of that. ESG is a distraction from that. ESG supplants good governance with gestures.
Why is this happening? My guess is that the only way to raid the boardroom — if not by skill, talent, innovation, or experience — is to outfit a new generation of business culture warriors armed with ESG weaponry to force themselves to the top by any means necessary. Change the rules, become an expert of the rules, and you rule.
Bottom line to investors. I ran an informal poll on social media. One question: Would you rather your money manager optimize your income, or the environment with your IRA? You can only pick one. 95 percent responded, “My income.” 5 percent responded “The environment.”
ESG is hoping to flip that.
Andy Martin is a mutual-fund manager, product developer, and author of Dollarlogic: A Six-Day Plan to Achieving Higher Returns by Conquering Risk.