We have written previously about the enormous inflows of capital into so-called ESG (“Environmental, Social and Governance”) investing over the past ten years and the challenges ESG investing poses for investors. Over the past two years, we have begun to see pushback against ESG investing on several fronts. The critiques merit a closer look because they further complicate the challenges investors face when trying to decide whether or how to employ ESG criteria in their investment portfolios.
First, let’s revisit what we mean by ESG investing. The conventional approach to investing focuses on maximizing the expected return. For stocks, this approach considers a host of economic and financial factors relevant to a particular company with the aim of determining the intrinsic value of the company’s stock. Stocks whose market price is low, or at least fairly priced with respect to its intrinsic value, should have a high, or at least reasonable, expected return. Stocks whose market price is too high relative to its intrinsic value would have a lower expected return and therefore may not be a good investment.
ESG uses a more expansive notion of value than the expected return. ESG ascribes value to certain moral or ethical principles or policy objectives and then tries to identify “good” companies that align with those values or eliminate the “bad” companies which do not.
The conventional approach to investing aims to maximize the returns to shareholders. The ESG approach aims to maximize the good or benefit for a set of stakeholders broader than the shareholders. Investing to promote the interests of an expansive set of stakeholders as opposed to a narrow set of shareholders is a radically different concept. Some ESG proponents view society as whole as the stakeholders of any company.
Regulatory scrutiny. Recent pushback against ESG investing has come from several directions, one of which is regulatory: The SEC has been scrutinizing the manner in which some ESG funds are packaged and promoted. Several prominent banks are reportedly under investigation or have been fined for what is being called “greenwashing.” Greenwashing refers to providing misleading information about environmental or other ESG-friendly attributes of a fund wherein the investments are not, in fact, consistent with those objectives.
In 2021, the SEC issued its ESG Risk Alert bulletin, which did not attack the merits of ESG investing itself but highlighted some concerns: First, some ESG funds may not be practicing what they preach. The SEC stated: “Actual portfolio management practices of investment advisers and funds should be consistent with their disclosed ESG investing processes or investment goals.”
Second, the SEC highlighted the risk to investors arising from the lack of standardized and precise ESG definitions: “(t)he variability and imprecision of industry ESG definitions and terms can create confusion among investors if investment advisers and funds have not clearly and consistently articulated how they define ESG and how they use ESG-related terms, especially when offering products or services to retail investors.”
Does ESG investing perform well for investors? The implicit promise with ESG investing is that investors can do well (achieve market like investment performance or better) while doing good (advancing ESG goals). The data so far is limited and inconclusive.
In some years (i.e., 2016-2020) ESG funds have done well relative to the broad market largely because they were heavily allocated to tech stocks and tech stocks have done better. More recently, ESG funds have lagged as tech stock have faltered and energy stocks have outperformed. This limited performance history may have more to do with the natural ebb and flow of performance across economic sectors than with the long-term investment merits of the more virtuous ESG stocks. Keep in mind that most ESG funds have a relatively short performance history.
Moreover, there are reasons to be skeptical of the ability of ESG funds to deliver better returns over the long-term. Princeton economist Burton Malkiel has argued that an increase in the demand for ESG funds may cause their share prices to rise and enhance their returns in the short-term. Over the long-term, however, elevated valuations for such funds would mean lower expected returns. ESG funds also typically cost several times more than comparable index funds, creating another hurdle for future performance. According to Malkiel, informed ESG investors should be willing to accept lower, not higher, long-term returns.
Does ESG investing promote “good” outcomes? Does ESG investing change corporate behavior? That is the point after all. Does it advance the objectives it promotes? A study published in 2021, “Do ESG Funds Make Shareholder-Friendly Investments,” examined whether ESG funds in fact selected stocks whose companies had better track records advancing ESG-friendly objectives. The study, published in the Harvard Law School Forum on Corporate Governance, found no evidence that they do.
“We find no evidence that ESG funds’ portfolio firms outperform non-ESG funds’ portfolio firms with respect to most of the measures of stakeholder-centric behavior that we consider in this paper.” The study considered a range of corporate behaviors, including compliance with environmental, labor or consumer laws, and carbon emissions, board composition and other aspects of corporate governance.
The authors concluded that “socially responsible funds do not appear to follow through on proclamations of concerns for stakeholders.” They wrote: “We find that ESG funds’ portfolio firms have significantly more violations of labor and environmental laws and pay more in fines for these violations, relative to non-ESG funds issued by the same financial institutions in the same year. Moreover, we find that ESG funds’ portfolio firms, on average, exhibit worse performance with respect to carbon emissions.”
In an op-ed piece appearing in USA Today, BlackRock’s former Chief Investment Officer for Sustainable Investing, Tariq Fancy, had this to say: “… our messaging helped mainstream the concept that pursuing social good was also good for the bottom line. Sadly, that’s all it is, a hopeful idea. In truth, sustainable investing boils down to little more than marketing hype, PR spin and disingenuous promises from the investment community.”
We don’t know whether the authors of the Harvard study or the USA Today op-ed have an ideological or other axes to grind, but their concerns are shared by other prominent figures, including the SEC.
ESG investing has been around for decades but the ESG segment of the markets was a financial backwater for most of its history. At an estimated $40 trillion worldwide, that is no longer the case. You can color this author skeptical that $40 trillion of equity investments are wonderfully ESG compliant.
The critiques presented here are not a conclusive indictment against the idea of ESG investing. Proponents believe that ESG investing is a noble idea; but critics believe that ESG investing is a pernicious attack on shareholder capitalism. As is so often the case, the truth may lie somewhere between the extremes.
Intelligent investing in general demands that investors be informed and careful. In this case, ESG investing calls for an even higher degree of scrutiny and due diligence.
David Peartree JD, CFP® is an investment advisor with Brighton Securities Capital Management. This column is a collaborative work by David Peartree and Patricia Foster, Esq. Patricia Foster is a securities law attorney with substantial experience advising members of the financial services industry. The information in this article is provided for educational purposes and does not constitute legal or investment advice.