Ethical Investing: Some thoughts on ESG funds
I am suspicious of much modern ESG investing. It’s great that investors want to invest in bona fide ESG funds for the purposes of conscious capitalism, saving the planet and all that. From a “positive use of your wealth” as well as a “making more $$ by not holding miners” perspective, this is sensible.
However, I do wonder how much of the ESG approach stands up under the microscope. ESG funds often claim to deliver outperformance relative to ‘vanilla’ funds, due to their ESG framework. This doesn’t make sense to me.
I wonder – what do ESG funds do that your garden variety fund doesn’t? Is it that parts of the ESG approach add value, or is it that non-ESG funds (i.e., the comparative sample) are not doing their job to the kind of minimum standard that an investor should expect?
I know that there is real demand for genuine ESG funds. I think they are a beneficial addition to the investment universe and may actually deliver some social good. There still seems to be a disconnect between their advertising and what is actually being delivered. Consider these factors:
Environment – miners/oilers, cleanup, environmental risks (spills etc), waste products (slag/tailings, chemicals), electricity/water requirements, relationships with locals (Exxon Valdez, Samarco), hacking/ data security
Social – sweatshops in China, child labourers in African cobalt mines, abusive business models (e.g. gambling), predatory lending, poor treatment of employees (e.g. illegal underpayment) & I would argue things like franchisee abuse also fall into this category
Governance – are the board & mgmt aligned with shareholders or feathering their own nest? Are incentives and other governance issues (e.g. trust accounts, related parties, etc) in order? Is the asset manager willing to vote ‘no’ and/or potentially advocate for changes in problematic areas?
It is my amateur view that analysts/managers that do not form a view of these issues when buying a company, are literally not doing their job. While there are of course differences between funds, it should not be possible for ESG funds to achieve a sustainable performance advantage simply by analysing these types of issues and avoiding the worst risks.
As a result, the ESG claim of outperformance does not intuitively make sense to me. While the evidence of outperformance itself is convincing, I do not believe that it is due specifically to ESG factors. I would guess that the claimed outperformance comes as a side effect of the ESG approach, via a couple of factors:
- Avoiding many weak/cyclical business models (miners, oilers, subprime lenders)
- Selecting firms with better governance (research suggests that better governed firms perform better)
- Running a genuinely active approach (in combination with #1, above) relative to index hugging funds
- Being measured against a relatively lame sample of non-ESG funds
ESG firms are also a smaller part of the market relative to the ‘vanilla’ funds that they are being compared against, which makes me wonder if there is a size effect to consider.
It is hard however to make a concrete judgement either way because the data I have seen is not ideal. Definitions of ESG funds vary and of course ESG investment strategies differ widely. Some research measures “responsible” funds relative to the average large cap equity fund. I have read a number of articles/ reports like this from Canstar and RIAA over time, but if someone could send me a convincing report of decent length, I would appreciate it. This chart from RIAA shows ‘Responsible‘ fund performance vs regular ‘Large-Cap’ funds:
Fork me with a hot poker, being a responsible manager of investor capital achieves better returns! How could we have known? (amazing…)
With ESG I very strongly doubt that a criteria like gender equality, for example, is a material contributor to investment returns, yet it is a metric on which some funds can measure companies/ management teams/ boards. I’d love to see more women on boards, because successful women are a powerful social good (Rowena Orr, amiright?), but, investing in companies with more equal representation should not deliver 2.5%p.a. extra performance over 10 years.
I know that that is only one metric, but it just doesn’t make sense. Investing in companies with a great culture that achieve equal representation as a by-product of a great culture for example, makes a lot of sense when it comes to achieving higher investment returns. But that is very different to using a static criteria – and notably, non-ESG funds should be able to identify a great culture just as easily.
I think in certain circumstances, another common criteria like a mandated number of independent directors could be damaging to performance. Ben Kerry recently shared this letter from Constellation which gives a decent explanation as to why. I’m sure there is no shortage of companies that need better boards, more female reps, and more independent directors – but putting warm bodies on the board so that they can meet criteria is an exercise in box ticking. The real situation is likely far more nuanced and requires a case-by-case evaluation, and this is something that an ordinary manager should be able to do just as well as an ESG fund.
My point is that much of the ESG approach, such as selecting for better governance and avoiding poor business models, is already available to and utilised by non-ESG funds. As to some other ESG metrics, I am not convinced that they, in and of themselves, deliver greater investment returns.
Having said that, there are elements of the ESG approach that I believe do add performance value. A company focus on treating employees well, for example, is not a make-or-break investment criteria for most of the investment managers that I read. Still, there are enough examples of treating employees well (Costco) and poorly (Amazon, Walmart) that I can believe this part of the ESG approach adds value.
If there were 1000 Amazons, and 500 of them treated employees well and 500 treated them as the current Amazon does, for example, I would bet that there is a robust statistical difference in performance between the two groups over time. In any one situation, like the current Amazon, employees don’t need to be that happy for a company to deliver great performance. Over time & repeat iterations however, things like regulatory risk and unionisation may catch up. I think this part of ESG may add genuine value.
On another front, given that many ESG firms are boutiques, I don’t think it is easy to say that the ESG approach itself generates outperformance when the comparison field is large cap retail managers like Perpetual. A more appropriate comparison (when determining if the ESG approach itself delivers outperformance) would surely be boutique non-ESG managers. Look at the above chart – the comparison large cap managers haven’t even matched the index over the last 10 years. It’s not exactly a strong comparison sample.
I see it this way – in reality ESG funds (and many other funds) may tend to outperform the average large cap retail fund. But in a perfect world, comparing a large sample of pound-for-pound identical funds with the only difference between them being the ESG vs non-ESG strategy, it is my view that much of the claimed performance benefit of ESG would disappear.
I am sure that there will be howls of protest, but I think that much of the claimed performance benefit of ESG funds is likely down to a) a better pool of candidate companies, b) selecting for better governance, and c) being compared to a bunch of mediocre closet indexers, rather than ESG criteria in and of itself being a driver of greater performance.
I consider ESG factors when I invest and, all else being equal, I would far prefer to put $ into ethical and sustainable companies. But ESG is quickly becoming a buzzword, and I think it is crucial for would-be ESG fund members to consider why the claimed benefits of ESG are actually being delivered.
I have no financial position in any company mentioned. I am not employed by and do not have any financial relationship with any asset management firm or ESG firm whatsoever.
I disclaim that this is a general article. I am aware that not all ESG firms are smaller boutiques, and that not all large cap managers lag the index. There is clear potential for sampling error and bias in every claim I have mentioned above. I still think I make a fair point that is worthy of discussion.