Last week my colleagues at ETF Stream held a great event on ESG ETFs. You can see more about this cracking event HERE . I moderated two of the panels and hopefully, I managed to keep my rampant cynicism about ESG investing under wraps.
But I’ve now come to the conclusion that rather like Smart beta, ESG investing as a mass-market phenomenon is ultimately doomed. Obviously, the stats surrounding ESG fund flows suggest that I’m way off base, with more money than ever flooding into funds with an environmental, social, and governance angle but I think the seeds of destruction have already been sown.
Let’s first rehearse the core arguments.
The most effective criticism is that the acronym ESG covers far too many bases for any meaningful fund investment allocation policy. There is no internal coherence between these ideas and thus it ends up turning into a giant exercise in ticking boxes and data fakery aka greenwashing. I happen to think that some of the underlying objectives identified by ESG frameworks are important – especially around social responsibility and reducing carbon emissions. But I’ve long felt that yoking these myriad objectives into one screen or ‘factor’ is ludicrous. Take tech stocks for instance. These have low carbon footprints but also happen to massively overpay their CEOs, refuse to let unions into workplaces, and generally have poor corporate governance as a result of different classes of shares. Which should take priority? Low carbon footprint or poor social measures? In my view, we shouldn’t even be comparing apples with pears i.e they belong in different investment strategies.
The next deadly attack comes from the impact lobby, of which I am hugely supportive. Most investors motivated by ESG want to either see a simple exclusion criterion – perfectly reasonably – or some direct impact that in a short period of time improves a clear policy outcome i.e reduce emissions or helps put a roof over the head of the homeless. They are less interested in opaque points systems that reward an oil company that happens to invest in a few wind turbines.
There is though a wrinkle in this argument around engagement. One can see an argument for an ESG style investor haranguing an oil company to improve their methane emissions policies – but in truth most fund managers have neither the time nor the disposition to be a pain in the ass with corporates.
The final nail in the coffin for me is the clever ruse of saying that ESG is not a factor designed to produce outperformance but then quietly point to fantastic returns from previous ESG implementations. “Of course this isn’t about alpha but if it happens to produce outperformance as a side effect then that simply proves our point” is a sentiment I frequently hear from ESG types. This defense will crumble when the tide turns and ESG strategies mean revert and have a terrible few years, serially underperforming the benchmark.
My own personal hang-up about ESG as a strategy is that it acts as an expression of groupthink – in this case, a liberal, upper-middle class, educated, metropolitan form of thinking that has an orgasm about the thought of buying an electric car but is curiously uninterested in complex problems like decarbonising the construction industry (which requires lots of engineering challenges) or off-topic subjects such as workers’ rights.
I may be a great believer in markets and the dynamic power of capitalism, but I have fairly old-fashioned social democratic views about the S bit in ESG. I happen to think that having happy workers makes sense. I also happen to think that paying obscene amounts of money to CEOs is…obscene. I’m more amenable than many of my peers are to trade unions – properly run and not dominated by lunatic Marxists. I’m probably slightly less excited about identity-based recruitment policies but also believe that cognitive diversity and an active commitment to listening to worker’s views via board representation makes absolute sense. On these kinds of subjects, I tend to hear deafening silence from most financial professionals. When I mention them at events one can hear the tumbleweed crashing up onto the stage.
I accept that these are my own particular preferences but until now I’ve lacked the hard evidence which backs up why I think the social bit of ESG is hugely important.
I said until now because Liberum’s excellent strategist Joachim Klement yesterday provided me with some hard evidence for taking the S seriously. In a short note called “Does the S in ESG matter?” Klement points to research from the Otto Beisheim School of Management in Germany which shows that the social element of ESG may be the most important contributor to corporate valuations [ my emphasis].
The study he cites looked at more than 23,000 companies in 35 countries and their valuation (measured as Tobin’s Q) from 2003 to 2016. Running several different regressions, they looked at the impact a better E, S, and G score had on company valuations.
Here’s Klement on the results:
“Interestingly, a 30% improvement in the social rating of a company had the biggest effect, creating a 19% increase in corporate valuation, while an improvement along the environmental and governance dimension increased corporate valuations by 14% to 15%. But if the researchers looked at the influence of all three dimensions together, they found that the environmental and governance dimensions often had no significant influence on corporate valuations or a much smaller one than when assessed individually….any changes in environmental ratings were inconsequential to the valuation of a corporation.”
Let me offer one explanatory framework for understanding this. Eco shaming and being seen to do nothing about your business’s carbon footprint will soon become an exercise in groupthink. That’s a good thing for the planet but let’s be honest if you do nothing you’ll be shamed into doing something. There will probably be no great comparative advantage to going green because everyone else is doing it because they think it is the “right thing to do”. Which it is.
When it comes to treating employees fairly by contrast and by that I don’t just mean fine words but actual hard policies – which cost businesses money in the here and now – there’s no consensus. Most employers know that building a positive workplace culture takes hard work and lots of time and a huge amount of management time. This is why most don’t really bother and choose to leave it to tick box HR processes which achieve absolutely nothing except annoy people.
So, there’s no real groupthink pressure to advance the S bit and in fact, there might be some short-term pain. That means those businesses that persist with these policies will probably experience a classic J curve effect – short-term pain, long-term gain over their peers.
Another way of putting it is that most businesses won’t bother and thus those that do and succeed will have an advantage that will eventually show up in compounding returns. I’d also conjecture that those businesses with happy workforces tend to exhibit less volatility – we can see that being played out now in UPS which is unionized and has low staff turnover versus FedEx which has high staff turnover and whose share price has consistently underperformed.
At some point, investors will realize that the emperor has no clothes and that ESG strategies are capturing the WRONG outcomes and impacts. At that point, ESG will probably go the same way as smart beta – last decade’s great fad. It will be replaced in turn – I hope – by a more careful and forensic series of micro strategies and measures designed to capture real impacts that matter to the end investor.