ESG Investing and the Battle of "Good vs. Evil" Investors
By Brian Seay, CFA
Founding Partner, Capital Stewards
ESG investing, otherwise known as Environment, Social and Governance factor investing has been in the media lately. Here we will look at data and provide fresh perspective on what ESG means, and how investors should view ESG. First, it’s important to understand what ESG really means and what "socially responsible investing" has meant for returns over the last decade.
What does ESG mean?
ESG stands for environment, social and governance factors. ESG investing means taking ratings on those topics into account when deciding to include or exclude assets from an investment portfolio. Environment factors consider items like carbon output, green energy, pollution and deforestation. Social factors include diversity, labor standards and even customer experience. Governance generally includes the makeup and function of the board of directors and executive team. Various organizations rate companies on each of these factors, and then those ratings can be used to include or exclude investments from portfolios. It’s also important to point out that just like each factor means something different to each of you, they mean slightly different things to each rating organization. Companies that score well in one ESG model, may not score as well in another ESG model. So there is even debate over how to consistently rate companies on these issues.
Real Data on Performance and Fees…Its Not What You Think:
ESG funds have outperformed over the last decade, so they must be superior right? The answer is no. ESG itself does not lead to higher investment returns. In a recent study at Scientific Beta, the research team isolated the ESG factors and looked at returns separate from other factors like industry weights. Their results indicate that the "positive alpha" for ESG can be linked back to standard investment factors like financial performance and industry exposure.
ESG did outperform, until 2022, when many ESG funds are down more than their broad market peers. Let’s take a deeper look at what actually drives returns. We will compare Vanguard's ESG U.S. Stock ETF (ESGV) to Vanguard's Total Stock Market ETF(VTI). Since the inception of the ESG ETF in 2018, it has outperformed the broad market fund by 2%. In 2022, the ESG ETF is down 3% more than the broad market index ETF. When we look further into the holdings, we see that the ESG fund owns almost no energy stocks, has very few utility stocks and has substantially more technology and growth stocks to round out the portfolio. That is consistent with its ESG mandate. Over the last decade, interest rates were low and growth-oriented technology companies outperformed the broader market. This year, they have underperformed, and energy and utility companies have led stock markets.
ESG portfolios are almost always tilted heavily to technology and growth stocks for two reasons. First, simply excluding energy stocks from a portfolio means that everything else will be more important. Second, tech and growth stocks score well on many ESG models because they have low environmental impact and are often focused on other social objectives.
You can see in this example the results of the Scientific Beta study. ESG itself doesn't contribute meaningful performance; the resulting portfolio tilts drive returns. It is likely, given what we know about these portfolio tilts that accompany ESG strategies, that ESG will outperform when the economy is doing well and when rates are low. ESG will subsequently underperform when things are going poorly. Perhaps providing similar returns to broader markets but with more volatility.
Fees are also an important consideration. In our example, the Vanguard Total Stock Market ETF costs 0.03% on an annual basis. The ESG U.S. Stock Fund is three times as expensive at 0.09% per year. According to Morningstar’s U.S. Fund Fee Study, the average fee for broad market mutual funds and ETFs is 0.39% and the average fee for their ESG counterparts is 0.55%, a whopping 41% premium for ESG. No wonder asset management firms are marketing "green" strategies.
A Better framework for Impact:
So now we know that ESG itself does not contribute to portfolio performance and that ESG costs more to implement in a portfolio. Does that mean investors shouldn't use ESG funds? Is there a better approach?
The answer is it depends on your personal preferences. We typically ask clients who are considering ESG investing two questions:
If your ESG preferences result in lower returns, are you ok with that outcome?
If your ESG preferences create more portfolio volatility, are you ok with that outcome?
If the answer is yes to both, then ESG may be something to consider. If the answer to one of these questions is no, does that mean I’m an “evil non-ESG investor?” No! You do not need to choose between investment performance and positive impact. For clients that want to invest in making the world a better place, we recommend a more impactful approach.
Invest your portfolio for optimal performance and then take the excess returns and give to local non-profits that make a real difference in your local community. You can build a park, sponsor habitat houses, or feed many families for the difference in fees alone. When you invest in an ESG fund, you hope that your decisions plus the collective investment decisions of others will have an impact on the decisions of massive companies that rely on billions (or trillions) of dollars in capital. Does $200,000 or $500,000 or $5,000,000 in an ESG fund change corporate decision making? When you use your capital to invest in the local community, you can be sure that your dollars are being used to accomplish your intended goals.
Should Pension Funds and 401k Plans Use ESG Investing?
Now, let’s discuss investing on behalf of others. Because ESG factors alone do not drive risk-adjusted outperformance, our view is that fiduciaries, like pension fund managers and 401k sponsors, should not be forcing their participants to adopt ESG investing biases. When individuals choose to have an ESG focus in self-managed portfolios, they make their own choice, hopefully with quality information about the risk-return trade-offs. When individuals are investing in a pension fund or 401k, others are making decisions on their behalf. These decision-makers are fiduciaries charged with looking out for the ultimate beneficiary’s best interests. The fiduciary duty of these managers requires them to be solely focused on achieving the financial goals outlined by the pension fund or 401k plan. Anything less is a breach of their duty to their investors. Simply screening out industries like energy or requiring an ESG score threshold seems inappropriate.
This doesn't mean that ESG should be abandoned all together. Boustanifar and Kang published a paper this summer in the Financial Analysts Journal on the excess returns created by having satisfied employees. We know that well-run businesses that create value for society tend to do well over time. A business that is violating pollution laws is likely a poor investment. The same is true if a business cannot attract and retain top talent through employee satisfaction. These "ESG" factors should be considered by active managers as a one component their analysis in buying or selling a company. Those factors may be key to whether the investment provides excess return or not. However, viewing ESG as part of a broader puzzle is a much different approach than simply screening out entire industries or stocks based on an ESG rating.
So the issue is more complex than meets the eye. ESG is not a "good vs. evil" concept. It should not be used blindly but also should not be ignored.
References
Scientific Beta, “Honey I Shrunk the ESG Alpha,” April 2021. https://cdn.ihsmarkit.com/www/pdf/0521/Honey-I-Shrunk-the-ESG-Alpha.pdf
Boustanifar and Kang, “Employee Satisfaction and Long-Term Stock Returns,” May 2022. https://www.tandfonline.com/doi/full/10.1080/0015198X.2022.2074241