ESG funds, which are mutual funds and exchange traded funds (ETFs) that consider Environmental, Social and Governance factors in their investment decisions, are plagued by vitriol and misinformation. This partly stems from the amorphous nature of the term, “ESG.” I am reminded of the parable of the blind men and the elephant: in James Baldwin’s retelling, six blind men, upon feeling different parts of an elephant, decided that the animal variously resembled a snake, a tree, a wall, a rope, a spear, and a fan. Baldwin concludes the story with the men quarreling all day. “Each believed that he knew just how the animal looked; and each called the others hard names because they did not agree with him. People who have eyes sometimes act as foolishly.” In our case, ESG is the elephant in the room.
ESG has a long ancestry. It evolved from the centuries-old practice of ethical investing by religious groups who avoided “sinful” industries. To this day there are ethical funds that screen out disfavored industries (negative screening), among them tobacco, alcohol, gambling, pornography, firearms, coal and other fossil fuels. The term “ethical investing” has gone out of fashion, however, and these types of funds are more generally known as “SRI,” or socially responsible investment funds.
“ESG” itself dates from a 2004 United Nations Global Compact report. The report was co-sponsored by financial institutions, including the largest European banks as well as Goldman SachsGS and Morgan StanleyMS, and ethics were barely mentioned. Instead, good environmental and social practices, and the corporate governance structures to successfully manage these, were portrayed as money-making opportunities: “Companies with better ESG performance can increase shareholder value by better managing risks related to emerging ESG issues, by anticipating regulatory changes or consumer trends, and by accessing new markets or reducing costs.” This reframing allowed the financial industry to capitalize on consumers’ preferences to buy and invest ethically and sustainably, while maintaining a reputation for financial hard-headedness.
The idea that investors can use ESG analysis to manage the financial risk of environmental and social issues to their portfolio holdings has withstood the test of time. MorningstarMORN claims that “these factors—environmental, social, and governance—come down to the bedrock of investing: risk.” The Global Risk Management Institute agrees: “ESG frameworks help companies shift from compliance-driven mentalities to proactive risk mitigation tactics.” SRI may be about ethical investing, but ESG is about controlling financial risk. Nevertheless, both approaches are lumped together under the ESG moniker because while their intentions differ, their tactics may overlap. And the tactics are many and varied. In addition to negative screening, there is also positive screening, stacking the portfolio with companies that exceed a certain threshold of good conduct. Some funds restrict investment to pro-social themes, such as healthcare. Some funds own broad swaths of the market, but adjust the weights of the portfolio to tilt toward companies with better social and environmental characteristics. And some funds use their holdings to try to persuade companies to change their behavior. Like the elephant, ESG resembles many different things at once, and debates about the topic generally concern people who each believe that they know just how the animal looks, talking past each other.
In our polarized society, ESG funds are disparaged by those who believe that this type of investing shifts the behavior of the corporate sector in undesirable ways, leading to threatening social change. Two main critiques are offered: first, ESG investing violates the obligations of fiduciaries to solely focus on financial benefits for their customers and retirement plan participants, instead favoring social and environmental policy goals of no financial significance. Those who subscribe to this view have their hand on the “ethical investing” part of ESG, while disregarding the financial risk management aspect of its anatomy. They do not argue that the risk management aspect is invalid, however, because the weight of evidence supports the assertion that ESG analysis does reduce downside risk.
The second critique is that ESG funds should be avoided because their returns are lower than comparable funds that don’t consider environmental and social risk factors. The evidence here is inconclusive. But a simple analogy will show that this critique is a red herring.
A risk reduction strategy with which we are all familiar is insurance. We pay for a policy in order to reduce the risk of incurring significant expense to repair a car or a house. What would you think of an insurance company that gave its policies away for free, or even paid you to sign up? Too good to be true? A free lunch? We should think of ESG funds the same way. We buy ESG funds to reduce the downside risk to our investment portfolio. Higher returns along with lower risk is the epitome of a free lunch, and we in the financial world aver that there is no such thing. The risk-return trade-off is the first thing we learn in introductory finance.
A third critique comes not from the right-wing but from academia and former sustainability chiefs, such as Tariq Fancy, Desiree Fixler and Stuart Kirk. This critique centers on another region of the ESG anatomy, impact. The old saw, “doing well by doing good” implies that ESG funds have positive impacts on society and the environment, allowing us to change the world while we make money. But whether ESG funds have actual impact, or merely trumpet empty, and sometimes fraudulent claims, is in serious dispute.
There are two main ways for investors to shift corporate behavior. One is ostensibly through portfolio allocation: by withholding capital from certain companies or industries, and allocating capital to others, investors might be able to expand sustainable industries and shrink unsustainable ones. The other is through engagement, in other words closed-door persuasion or voting at corporate annual meetings.
The trouble with portfolio allocation is that most ESG funds hold public market stocks or bonds. These are traded among market participants without any direct effect on the financing of the corporation itself. Some market participants claim that the level of buying and selling influences a company’s cost of capital, but this idea has found little academic support. Owning an ESG fund might make you feel good that you don’t have stock in a company you hate, and it might make you feel good that your fund has lower embedded downside risk, but it shouldn’t make you feel that you are helping the planet and society, because you probably are not. In this regard, conservative opponents of ESG funds have little to fear.
There are glimpses of progress, however. Certain pension funds in the U.K. are now practicing a philosophy of “engage our equity, but deny our debt,” backed by academic research. An ESG fund that follows this approach would refuse to invest in primary market debt issuances of undesirable firms, choking off needed capital, while using its secondary market equity to vote for sustainable shareholder resolutions, director elections, and say-on-pay resolutions. While I am not aware that this type of fund yet exists, if you find one, your participation will satisfy all of the goals of sustainable investing.
ESG can be a spear, creating pointed change, or a fan, providing comfort but little else, or even an obstructive wall. The current damaging political rhetoric concerning sustainable investing is a form of willful neglect that cannot be resolved unless we open our eyes to see the entire animal.
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