At the end of every post there’s a disclaimer that, among other things, emphasizes that 1) opinions expressed are my own and 2) are not intended to be investment advice. I want to stress those points for this post. The Truepoint Investment Committee is a deep roster of brilliant investment professionals with the diversity of thought and research skills necessary to understand financial concepts from all angles. The Committee deploys that knowledge in a fiduciary manner to serve Truepoint clients. Conversely, this is a ranting blog post written solely by me, unreviewed by the Committee, and shouldn’t acted upon as investment advice. That said, let’s talk about Environmental, Social, and Governance Investing (ESG).
Note: I’m going to use ESG as a generic term that includes a variety of investing strategies based on the idea that you can invest in companies that do good or align with your values. Other strategies include Socially Responsible Investing (SRI), Impact Investing, Green Investing, and at least a dozen others. Each varies in its goals and process, and nuance certainly matters, but for this post I’m going to use the generic term ESG.
ESG is one of the most-discussed topics in finance. It was the 10th most searched topic on Investopedia in 2019. According to this report, assets in ESG strategies total $12 trillion(!), and are rapidly growing. According to 2019’s Global ESG Survey, 78% of respondents said ESG is playing a growing role or becoming an integral part of what they do. The topic has hit mainstream with headlines like ESG Investing Comes of Age, The Remarkable Rise of ESG, and ESG Investing Hits Mainstream. Individual investors are becoming more aware of ESG, and many are wondering if they should include it in their portfolios. I applaud these people. Anyone willing to “put their money where their mouth is” by aligning their investments with causes personal to them inspires me. The world has an abundance of virtue signalers and hypocrites – we could use more people willing to “walk the walk.” The problem? I believe ESG is a creative Wall Street marketing ploy that is very effective at increasing their revenues and very ineffective at genuinely making a difference.
Before defending my belief, I want to point out the primary megatrend over the last decade in investing – the rise of passive management.
Passive investing/index funds are the single greatest innovation for retail investors, and since the financial crisis, investors have seen the light. Passive is still a small portion of the overall market; however, an increasing number of investors have embraced the low-cost, low-turnover, tax-efficient, broad diversification that index funds provide instead of expensive, tax-inefficient, underperforming actively-managed funds.
According to this report from 2017, the average expense ratio for an actively-managed mutual fund was 0.78%, vs. just 0.09% for index funds. That may not seem like much, but on trillions of invested dollars, this represents a massive hit to traditional Wall Street’s revenue. It’s not just expense ratios that are declining – the entire industry is feeling pressure on fees. In the old days, “diversifying your portfolio” meant paying your broker a management fee to buy dozens of stocks or active funds (incurring significant transaction fees and sales fees), resulting in a hodgepodge portfolio that likely underperformed the market. Today you can buy market exposure with a 0.00% expense ratio while incurring $0 transaction fees. It’s easy to see Wall Street’s dilemma: People want index funds, but index funds are basically free, and making money is pretty high on the Street’s list of to-dos. Their solution is to market and sell index-ish strategies with cheaper-than-active but costlier-than-passive expenses. Here’s how I imagine the pitch going:
Investor: I’d like an S&P 500 index fund
Wall Street: Absolutely, but let me ask you a question first: Do you consider yourself socially responsible? Do you care about the environment? Do you want to invest in “good” companies?
Investor: I guess so
Wall Street: Great! This S&P 500 ex-Coal (or ex-Guns or ex-Alcohol or ex-whatever-bad-thing-you-don’t-agree-with) fund is perfect for you! It has some extra cost, but you can get the passive management you desire and make the world a better place at the same time!
Investor: Gee, thanks Wall Street!
In my view, the rise of ESG is driven more by Wall Street than investors. The financial press is a large and powerful machine, and without the constant attention given to ESG, I’m not sure investors ever would have asked for these products. I think there’s a noncoincidental link between the proliferation of indexing and ESG, but perhaps I’m being too cynical. Ultimately, the engine behind ESG’s rise wouldn’t be a concern if the products were doing what they purport: Making a positive difference, punishing bad actors, and helping investors align their portfolios with their values. Let’s dig into why I don’t believe that’s the case.
1. Secondary markets aren’t an efficient place to enact change. When you decide to buy or sell a stock, usually you’re doing so over a public stock exchange with another investor on the other side of your trade. If I want to buy a share of Facebook, I’ll exchange cash at the current market price to receive one FB share. My cash doesn’t go to Mark Zuckerberg’s pocket or Facebook’s company vault; it goes to the person who sold me the share. Facebook won’t even be aware the trade occurred. Initial Public Offerings (IPO) are a different story, but IPOs are a tiny fraction of daily global trades. Cullen Roche compares stock market trading to betting a horse race – you can wager as much as you want, but your bet doesn’t impact the outcome.
2. You’re fighting an emotionless opponent. Adam Smith wrote in The Money Game, “A stock is for all practical purposes, a piece of paper that sits in a bank vault. Most likely you will never see it. It may or may not have an Intrinsic Value; what it is worth on any given day depends on the confluence of buyers and sellers that day. The most important thing to realize is simplistic: The stock doesn’t know you own it. All those marvelous things, or those terrible things, that you feel about a stock, or a list of stocks, or an amount of money represented by a list of stocks, all of these things are unreciprocated by the stock or the group of stocks.” You may feel better about yourself by scorning Exxon stock, but I promise that the Exxon stock isn’t feeling scorned.
3. One-size-fits-all solutions don’t exist. Your values are personal to you, what are the odds that they align perfectly with the fund manager’s definition of ESG? The iShares ESG MSCI USA Leaders ETF (SUSL) is the largest ESG fund with over $1.8 billion under management. According to its prospectus, it “excludes securities of companies involved in the business of tobacco, alcohol, gambling, nuclear power, companies involved with conventional and controversial weapons, producers and major retailers of civilian firearms, as well as companies involved in very severe business controversies.” Is that list comprehensive for you? What if you’re okay with tobacco but want to exclude the rest? Or what if there’s a cause personal to you that’s excluded from this list? Trying to list the major evils of the world reminds me of Michael Scott listing the four kinds of business. Subjective lists for exclusions aren’t going to insulate you from owning “bad” companies. Case in point: Johnson & Johnson, fresh off a controversy that involved them knowingly putting asbestos in baby powder, is now is under fire for its role in the opioid epidemic. It’s the 2nd largest position in SUSL.
4. The “seat at the table” argument. Owning a single share in a public company gives you a (small) voice. You get to go to annual meetings and vote proxies. You also receive dividends from the company. You might be able to use your voice to enact positive change. At the very least you can redirect dividends into “better” companies. If you sell your share, you may be giving up your seat to someone with no interest in advocating for change and who may also reinvest dividends back into the stock.
5. Looking under the hood of ESG funds may surprise people. Some ESG funds filter out companies with exposure to nuclear power as “controversial business involvement.” Other ESG funds specifically allocate a larger weight to nuclear power companies due to “low carbon emissions.” You’d never know the difference between the funds by merely looking at the names. Another example: Nuveen is one of the largest ESG providers, with over $20 billion in assets under management. Their Emerging Markets ETF (NUEM) understandably screens out companies from Sudan, but Saudi Arabian and Chinese companies comprise over 42% of the fund. Somehow Sudan’s human rights record is reprehensible while the other two are acceptable? Of course not – the reality is that China and Saudi Arabia are two of the biggest emerging market countries. If you exclude those, you risk underperforming your benchmark and other ESG funds by a longshot, and nothing makes investors bail on a strategy like underperformance. Looking under the hood of ESG funds results in headlines like ESG Funds Enjoy Record Inflows, Still Back Big Oil and Gas and Why Your Good Governance Fund Is Full of Saudi Bonds.
6. Today’s villains could be tomorrow’s heroes. Exxon Mobil is investing $100 million into clean energy research and development. Ford has announced an $11 billion investment into electric vehicle technology with a plan to develop 40 electric vehicles by 2022. Similar examples exist across other “sin” industries. There is assuredly an element of self-preservation behind these initiatives. Still, there’s also a high possibility that major positive breakthroughs will come from older and larger companies with the resources to invest in R&D.
7. One man’s cost of capital is another man’s return. This one gets technical but stick with me. Let’s say Evil Corp is about to go public via IPO or is already public and wants to raise money by issuing more stock at $100/share. If public investors largely decline to buy because Evil Corp is just too evil, the company won’t be able to raise their money by selling stock at $100/share. They’ll have to drop the price to maybe $95/share. If investors still refuse, the price will continue to fall. At a certain point (maybe $80/share), someone will say, “I don’t like Evil Corp, but now it’s too good a bargain to pass up,” and they’ll buy. This would be a “win” for the ESG crowd. Evil Corp couldn’t raise cash at $100/share because too many investors wanted to punish their evilness, and as a result they were forced to raise at a lower valuation. Their cost of capital is 20% higher due to their evilness. But the real winner is the bargain buyer at $80/share. He got to buy at a 20% discount. Some might deride this bargain buyer for abandoning his ESG principles. However, he now has an extra 20%, which he could use to make a bigger and more direct positive impact (spend it at Good Corp, donate to charity, or pay someone to mow his lawn so he has more time to volunteer after work). In the end, even when ESG strategies “win” by raising a company’s cost of capital, they’re also donating that excess return to non-ESG investors.
This post is not meant to bash ESG investors. As I mentioned before, their willingness to invest in accordance with their values is admirable. I just want investors to understand the shortcomings of ESG funds, which you’ll never hear from Wall Street because they don’t have your best interest at heart. Selling ineffective products to unsuspecting investors is nothing new for the Street, but this time they’ve also convinced investors that these products offer a moral high ground. As Nick Murray put it, “If you’re getting your very admirable philanthropic impulses mushed together with your for-profit investment policy, you’ll almost certainly end up with significantly less of both.”
Finally, this post was largely inspired by these articles from Cliff Asness and Cullen Roche. If you’re interested in learning more, reading those articles and asking your advisor are a good start.
Disclaimer: Truepoint Wealth Counsel is a fee-only Registered Investment Adviser (RIA). Registration as an adviser does not connote a specific level of skill or training. More detail, including forms ADV Part 2A & Form CRS filed with the SEC, can be found at TruepointWealth.com. Neither the information, nor any opinion expressed, is to be construed as personalized investment, tax or legal advice.