Coming Clean on Green
Environmental Social and Governance (ESG) informed investing is, by any commercial perspective, a success. Flows into ESG-oriented investment funds now dwarf even some of the most optimistic projections from a decade ago when it was still very much a niche category. Industry projections are for ESG’s parabolic rise to continue for years, especially in the US. And yet, this success appears to have come at a cost. The public’s understanding of ESG has been corrupted, with negative implications for the future.
The asset management industry began heavily promoting ESG funds more than a decade ago. However, pretty early on, the industry’s marketers realized it might take more than just good feelings to really bring in the AUM. They fell back on their old playbook of promoting investment strategies based on performance prospects. ESG was (and is) sold as a way to achieve guilt-free out-performance.
Partly as a result of this effort, the notion that ESG results in better performance has been cemented in the minds of individual investors. A recent survey by Nuveen indicated that a majority of consumers believe ESG will result in better returns or lower risk. Fully 85% of respondents agreed with the statement: “I will only invest responsibly if the returns are the same or better [than other investment approaches].”(1) This is problematic because there is no real basis to expect sustained out-performance from ESG strategies.
Many ESG strategies have indeed outperformed for many years. However, this out-performance is best understood as incidental rather than intrinsic to ESG. Specifically, ESG has tended to focus on stocks in certain sectors (tech) and stocks with certain factor exposures (quality growth). These sectors and styles have been consistently in-favor since the global financial crisis. Yet ESG methodologies may not always lead to these types of portfolio exposures, and in any case, these types of exposures will not always result in out-performance. In fact, if valuations for these types of exposures appear stretched (as they do at the time of this writing) then they may lead to under-performance in the foreseeable future.
Proponents of ESG like to explain that the methodology results in a broader lens through which stock analysts evaluate risks to the companies they follow. The thinking goes that incorporating this extra information into the stock selection process results in better decisions and better performance. This is mostly rubbish. Any stock analyst worth his salt has always been aware of (and weighed up) matters of governance, and - to the extent they may influence share price - environmental and social factors as well. The ESG lens introduces nothing truly new to the toolkit of a good equity analyst. At best, it may lengthen the time horizon over which they conduct their analysis of risk.
Lastly, market theory tells us that something like ESG cannot lead to consistent out-performance. If it were a reliable way to outperform, a majority of investors would adopt it, arbitraging away any risk-free excess return. That process might result in persistently higher valuation multiples for companies that score well on ESG metrics. It’s possible that we’re already seeing this.
Why does any of this matter? It matters because faulty expectations set investors up for disappointment. If a majority of ESG fund investors are there because they think it’s a way to have their cake and eat it too, then they’re likely to bail on ESG funds as soon as these funds lag the market for a year or two. That would be a shame because ESG has a lot to offer besides out-performance.
What ESG offers us is a way to collectively discipline capital markets through the ‘carrot’ of lower cost of capital and the ‘stick’ of public censure and proxy battles. ESG investing will never be an adequate replacement for thoughtful and comprehensive regulation. But in an age when governance in the West seems sclerotic if not downright paralytic, anything that leads us incrementally towards a kinder and gentler form of capitalism, is worth pursuing. ESG is a worthy endeavor, and a bright spot in the industry. We should all get behind it. But let’s do it for the right reasons. Let’s do it because aligning our actions with our values is always the right thing to do.
(1) Sixth Annual Responsible Investing Survey 2021, Nuveen.
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The information and opinions expressed herein are for general information and educational purposes, and may change at any time. They do not constitute investment advice and are not a solicitation for the purchase or sale of any security or implementation of any specific investment strategy.