The fallacy of ESG investing
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A single phrase sums up the appeal of environmental, social and governance investing: “doing well by doing good”. ESG strategies, we are told, promote the greater good and provide superior long-term financial performance.
For example, the world’s largest fund manager, BlackRock, wrote an open letter this year saying that “sustainability- and climate-integrated portfolios can provide better risk-adjusted returns to investors.” That is to say: over time, more virtue equals more money.
There are good reasons for investors to own portfolios that align with their values. This supposed win-win proposition is not one of them however. Not only is the evidence that ESG outperforms over long periods inconclusive; the win-win argument doesn’t even make sense.
It is true that at some point in the indefinite future, the social good and financial interests must converge. There are no investment returns at all on a planet left uninhabitable by climate change. But that is not the time horizon individual investors operate over (they might have just 20 years between acquiring significant assets to invest and retiring). And it is far beyond any corporation’s planning horizon.
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Over a realistic time horizon, a wicked or “anti-ESG” portfolio perfectly well might offer the best available return. There are two ways investments outperform: either they generate greater than expected cash flows over time (growth), or they are bought at a cheap price (value). Putting aside the question of growth, to argue that (say) a carbon, tobacco, and gun-heavy portfolio cannot outperform over the long term is to argue that it will never be bought cheap.
But of course it is the goal of the ESG movement to push investors away from “wicked” portfolios — making their prices cheap, and setting them up to outperform “virtuous” portfolios over time! The win-win pitch is a fallacy. Sometimes investors have to choose between their values and their pocket books.
Illogic is not the only problem with the win-win story. Another is performance attribution. ESG funds have had a nice run lately. Since its inception in late 2018, for example, Vanguard’s US ESG exchange traded fund return of 28 per cent has whipped its broad-market ETF’s 17 per cent. Look, however, at the holdings of the ESG fund. The top seven holdings, accounting for a quarter of the funds’ value, are Apple, Microsoft, Amazon, Facebook, Google and Tesla. Tech has led the market this year. But has ESG, really? And if tech stocks become overpriced and their prices crash, does that mean ESG is suddenly a bad strategy?
At best, companies with strong ESG credentials represent a certain set of investment attributes — a “factor” similar to company size, stock momentum, or profit growth. Whether any of these factors outperform over the long run is hotly debated, but it is certain that they can suffer very long periods of underperformance.
So a rigid commitment to any such factor is a formula for weak returns. I learnt this to my sorrow in the years following the great financial crisis. In the years leading up to 2009 I worked at a value-driven investment fund. It bought cheap stocks, followed tight risk controls, and did well — especially, in relative terms, during the crisis itself. So for years thereafter I avoided expensive growth stocks and kept my exposure low. But while my approach stayed the same, the market had shifted to favour growth. I made terrible returns and am poorer for it.
Investors who buy the win/win sales pitch are, sooner or later, likely to have a similarly painful experience. Because there is no particular reason, logical or factual, to expect that the strong relative performance currently enjoyed by the ESG “factor” should be a permanent feature of the market.
None of this suggests that investors should not put their savings behind the things that they care about. It means only that they should not think of this as a wealth maximising strategy. Indeed, accepting the possibility of lower returns in return for the promise of positive social outcomes, such as a healthier environment or less poverty, can make a positive impact by putting resources to work where an “efficient” market would not, providing subsidised capital to projects that are very risky but could have a big upside for society.
Society receives no benefit, however, from the Panglossian do-well-by-doing-good story. It only helps fund managers sell products and companies polish their reputations while avoiding hard choices. Follow your values, but keep your eyes open.
Robert Armstrong is FT’s US finance editor
Letters in response to this column:
Commercial success is key to ethical investing too / From Reynir K Indahl, Managing Partner, Summa Equity, Oslo, Norway
In ethical investing, it’s hard to find two to tango / From Savina Venkova, London SE18, UK
Finance belatedly finds its purpose with ESG / From Bruce Davis, Joint Managing Director, Abundance Investment, Visiting Research Fellow, Bauman Institute, University of Leeds, UK