ESG: The Battle of Good vs. Evil Investors

Should your values impact the way you invest? What is Socially Responsible Investing - or ESG Investing - and what does it mean for investors? In this episode, we discuss what ESG really mena and look at data to provide fresh perspective on ESG investing. We cover:

1) What does ESG mean? What is Socially Responsible Investing?

2) Do ESG factors lead to higher returns and better results for investors?

3) How should individual investors think about ESG investing?

4) Should those investing on behalf of others, like Pension Funds and 401K administrators, require ESG targets for their portfolios?

Transcript:

Is ESG investing

good or evil?

The

wicked, Wicked Witch of the West ,

ESG investing, The Battle of Good versus Evil? I don't

know.

So really that big of a, that's what I call it the article title is the esg, the Battle between Good and Bad Investors. Oh, Well, ain't that controversial? There are people out there that actually believe that there's good investors that are ESG investors, and then everybody else is just about, like the Robert Barons taking money from the poor and polluting the economy.

And the evidence is quite the contrary.

Do you wanna kick off the show now? All

right, friends, welcome back to another episode of The Six-Figure Investor. We're excited that you're here. Today we're gonna be talking about

ESG investing. What socially responsible investing, what does ESG mean? So esg, otherwise known as environment, social and governance Factor investing.

And it's been in the media a lot lately. It's kind of crossed over from a thing that we've been talking about in the asset management industry for a long time into the mainstream because of some things that are going on with pension funds and 401K plans, and we'll talk about that. Towards the end of the show.

But it also is something that I think investors, our listeners have become more interested in, right? Because it's how do I express not only my, my, you know, desire to make money in my portfolio, but if I have a particular social view, like I don't wanna buy cigarette companies, or I don't wanna buy you know, liquor companies, or I don't wanna buy oil companies, or I want to buy a lot of, you know, the healthcare companies or whatever it is that you're, that you're particularly passionate about.

Okay, I'm in.

so you said that ESG stands for environment, social and Governance Factors. Tell us a little bit more, like what does that really mean?

So, ESG investing means taking ratings on those topics into account when asset managers, your investment managers decide to include or exclude assets from your portfolio.

Environmental factors probably are the thing that folks are most aware of. That's things like carbon. Output sort of old school versus new school. Energy, green energy pollution, deforestation, all those kinds of things, social factors. And governance factors are a little bit more challenging to get our hands around, but, but social factors for the most part include things like diversity labor standards, even things like customer experience kind of get grouped into the social factor piece.

And then governance generally includes the makeup and function of the board of directors the executive team, how they work together how good of a job they do at advocating for shareholders. As you may imagine, what you may think is good for the environment is not necessarily what I may think is good for the environment.

And so just like we both have different views of of what some of those things mean, the ratings companies that rate companies on ESG performance actually have different methodologies and different scoring models that they use. And so one company might score well and one model, and one company might not score well in a model.

So there's a little bit of a debate even within the world of BSG investing on. How good one company is versus another.

why invest in esg?

So the, the case for investing in ESG tilted portfolios has been, well, so it's twofold, right? So one, there are, there are folks out there that say, Hey, I'm so passionate about one of those environment social governance issues that I'm going to make sure that the companies in my portfolio.

Adhere to my views, whether that's, you know, excluding something or, or in investing more in another area regardless of the returns. The other reason that people haven't investing in esg, and, and frankly probably the reason it became so popular is that over the last decade, ESG funds outperformed the broader market.

Why? Why did

they outperform?

So the answer is they outperformed not because of the ESG factors themselves but they outperformed because of some of those tilts that ESG managers have to make to express their views. So let's, you're probably, you're looking at me like cross I'd like they outperformed, but they did perform because of esg.

What does that really mean? Yeah, yeah. Example. So, So let's, let's look at a little bit of research. ESG did outperform over the last five or six years until 2022. And this year a lot of those funds are down more than their broad market peers. So if we take a little bit of a deeper dive into returns, we, if we look at Vanguards.

ESG US Doc Fund etf, a big broad market ESG focused etf that scores pretty well Since inception 2018, that fund has outperformed the broader market by 2%. That's pretty good. In 2022, that fund is down 3% more than the broad market. And when we look further into the holdings, what we see is that in this, this particular ESG fund in most esg.

They own no energy stocks. They have very few utility stocks. They have substantially more technology and growth stocks to round out the portfolio. And that's consistent with the ESG mandate. The folks have said, Hey, we don't wanna buy the big integrated oil companies. We want to buy more technology and more sort of new economy stocks.

And over the last decade, interest rates were really low and so. Oriented technology companies outperform their broader market. And then all that changed this year where they underperformed in energy and utility companies have led the market. So so ESG funds have outperformed. But when in, when investment firms have gone in and done research on what's driving that out performance, it's not actually the ESG factors themselves.

So there's a a company out there called Scientific Beta and they've done some pretty complicated research that involves long and short positions based on company's ESG ratings, trying to hold the industry weights or the sectors of the economy neutral in the portfolio. And what they found is that all of the positive alpha or that sort of extra return can be linked back to standard investment factors like financial performance and the industry exposure of the fund. So ESG portfolios don't actually outperform because they're good or because they score higher on ESG factors. They just outperform or have outperformed because we've been in an environment where portfolios that were tilted more towards sort of new economy, technology and growth stocks have outperformed.

Seems to me that this episode is really more about investing behind your values.

Oh, I mean is that's why people buy esg.

Yes. Stocks it. This episode is more about investing behind your values. . There's nothing wrong with ESG investing, but you should be, investing in a particular fund that has a bias towards or against environment social governance factors because you firmly believe in those principles, not because you think that the, somehow it's going to outperform the market.

Does that make sense? Yeah, that totally makes sense. I

think as a person, I struggle with this concept., my personal bias is that there's a pro and a con to every company. Like you talk about these high growth stock companies, but they also have cons that come with them.

Yes, They're high risk. But not just as an investment, also as a social tool.

Oh, yes, they do. So I think what you're saying is yes. One person might think that the best way to invest and be sort of socially responsible, they're investing is to not own oil stocks because they wanna be about green energy and technology.

Another person might say, Well, some of these big technology companies have a lot of privacy issues and I'm not really on board with that privacy issues. And so they,

I mean, there's research out in the world whether true or false that they make people have emotions that make them feel unhealthy. It seems like there's a downside

to every stock.

Yes. And so I, I think that's an important part of the logic here is that e what ESG is to one person is not what it is to another person. And so that's another piece of the challenge is as investors, you've gotta figure out what's really important to you. And because the returns are not better necessarily in the ESG world.

What are you willing to give up? Potentially return or take more risk for? Or not? When you think about your own portfolio,

What would you say are the pros or the cons to investing esg.

So I, I think the, the pros are ESG investing is a great way to invest behind your beliefs.

If you have a particular belief about the world and you hold it strongly enough to give up money to see it happen, then the developments that we've made in the industry allow investors to do that and be really specific in their portfolios, but what they wanna own and none of The con is that a lot of financial planning, the way that people think about retirement, is built around owning broad market indices, right?

And what those returns look like over long periods of time. And depending on the kinds of ESG positions that you take, your portfolio then doesn't look like those broad market indices anymore. And there are some, you know, the other thing that's important is some esg themes, if you will.

You can play out without having a whole lot of impact on your portfolio and others are more significant. So like an example of that, you can say, Hey, I don't want to invest in alcohol. Or you know, cigarette companies and you take four or five s and p type companies outta your portfolio and you overweight other consumer stable stocks and you're okay.

But if you say, I really don't want to invest in the defense industry, or in oil and gas, you're taking out an entire sector of the economy and that looks very different. And so ESG investing even, you know, even sort of within itself, you know, you can have really significant changes to your portfolio or you can have relatively few and accomplish what you're trying to accomplish.

So what does it look like from a free fee structure perspective?

So this is another interesting area because one of the reasons, and probably not 21 surprised that asset management firms have been talking a lot about ESG investing is that they charge more for ESG funds. So earlier we talked about the Vanguard Total Stock Market ETF versus the ESG US Stock Fund.

That the ESG US Stock Fund is about three times as expensive as that total stock market etf. , Morningstar the studies fees, of course and they, they publish a study every single year. And so the average fee for broad market mutual funds and ETFs is 0.39%. And the average fee for their ESG counterparts is 0.55%.

So there's a 41% premium for ESG investing versus non ESG investing. So no wonder everyone is talking about how great ESG investing is in the world. And, and that's another, when we talk about pros and cons, that's another downside to ESG investing. Again the framework has to be,. My values are so important that it's worth me paying extra both in asset management fees and also in portfolio return in order to see that outcome.

Awesome. What do you tell clients when they wanna talk about ESG

investing? Yeah, so we usually use kind of a two question to framework and, and given the conversation we've had so far, this probably won't be very surprising.

If your ESG preferences result in lower returns, are you okay with that outcome? Is the first question. And the second question is, if your ESG. preferences create more portfolio volatility. Are you okay with that outcome? And if the answer to both of those is yes, then maybe ESG is something to consider.

Because what you're saying is my values are so important that I'm willing to make trade offs in order to see them implement in my portfolio. If ESG was kind of cool cuz you heard about it and you might think it's a new thing that would drive more portfolio returns, then we don't think ESG investing makes a lot of sense because the evidence is that that's not really the.

Um, And so a lot of times too when we have this conversation, what I really encourage clients to do is say, Hey, if you wanna invest and make the world a better place, you can take your money tangibly in your community and you can do a lot of things with local nonprofits. And so invest, earn as much return as you can, and then you can take the money that you don't need to spend and you can build a park, give it to your church sponsor Habitat houses.

You can feed a lot of families for just the differences in fees alone that you're gonna pay for an ESG portfolio. Versus a non ESG portfolio.

So I've seen a lot

about ESG investing in the news recently. Mm-hmm. , Tell me a little bit more about that. And I think the question is really around should pension funds and 401k plans use ESG investing?

Yeah. So let's talk about investing on behalf of others. So, we talked in the first part of this episode about how ESG is not necessarily something that's going to drive Risk adjusted performance over time.

And so our view is that fiduciaries which is a complicated way for saying that people that are investing on behalf of someone else who are supposed to have their best interest at heart they shouldn't be forcing participants that didn't decide to opt into ESG investing strategies to opt into ESG investing strategies.

The fiduciary duty of those managers requires them to be solely focused on achieving the financial goals that are established in the pension fund or the 401k. Anything less than that is really a breach of their duty to investors. So simply screening out industries like energy or requiring an ESG score, threat, you know, threshold seems like it's not appropriate that.

Doesn't mean that ESG should be just abandoned all together. There was a paper that was published this summer in the Financial Analyst Journal and it pretty well established the excess returns that are created by having the satisfied employees. And we know that well run businesses, create value for society.

They tend to do well over time. A business that's violating local pollution laws is probably a poor investment. The same is true for if a business can't attract and retain top talent through employee. Um, So those ESG factors should be considered by managers as one component of their analysis of whether they're gonna buy or sell a particular company or invest in a particular fund.

Those factors can be really key to whether or not an investment provides excess return or it doesn't. But it's part of a broader picture of the things that are driving the economics of those of those companies, not just simply screening out industries or stocks based on ESG rating that the participants in the plan didn't necessarily choose.

So what we, what we can't do is impact the returns of the people that are in the plan because we decide that a particular point of view is important to take as a. . So the issue is more complicated, I think, than sort of meets the eye. And ESG investing shouldn't be used blindly, but I don't think it should be ignored