Thinking About ESG

August 4, 2021

Impact investing has been a popular theme in finance over the last several years as investors are looking to make a positive difference with their investable assets. The finance industry saw this demand and came out with various ESG – environmental, social, and governance – investment products to meet that demand. At this point there isn’t a consistent standard for ESG, but typically how it works is that investments are given a score for each of the three ESG components which combines to an aggregate ESG score. Some investments, like certain ESG ETFs, will take a popular index such as the S&P 500 and exclude companies that have low ESG scores. This would be considered an exclusionary ESG strategy. Other investment products will only invest in companies that are high scoring in certain categories, such as green energy companies. Those investments would be considered thematic ESG investments.

The idea for these ESG investments makes sense at first, but when I dug deeper, I realized that investing in a lot of these ESG investment products actually makes little to no difference in improving the world. For example, let’s say you buy a share of a publicly listed environmentally focused company. You might think you’re helping that company, but that’s not actually the case. When you buy a company’s stock, you’re not actually giving money to that company. You’re buying that stock from some other investor. The company sold these shares on the market a long time ago, and for the most part any share transactions between investors makes no material difference to the company. The company is not receiving any benefit from you buying their stock. The only impact you have on that company in this instance is the voting rights you get to vote on matters of corporate policy. But, because this company is already doing all the right things, you don’t even need to vote on matters of corporate policy. When we look at all of the ESG products out there, the majority of them are making no difference at all. Ultimately, this would be considered a form of corporate greenwashing. It is essentially a marketing gimmick being pushed by the large investment firms to make it seem like they’re making a difference, when they’re actually not.

Knowing all this, I think there could still be merit in ESG investing. While you won’t be making a difference in any world-changing initiatives, there is still a possibility that companies with strong ESG factors could outperform companies possessing weak ESG factors. Multiple studies have been done to determine whether ESG factors play a role in investment performance. My takeaway from reviewing several of these studies is that at this point it’s unclear whether ESG factors play a role in performance. Some studies say that ESG factors contribute to returns, while other studies say that ESG factors make no measurable difference in performance. With the academic literature being no help here, we really have to think more qualitatively on this one. When I consider the direction much of society is going now, I’m seeing a shift toward stakeholder capitalism starting to take place in the global economy. If this shift continues, companies possessing strong ESG factors will likely outperform, but I think to capture the ESG alpha it will likely require more complexity than just buying an ESG ETF and calling it a day. I think in-depth research has to be done to really capture alpha in this space, and I think those who are doing the necessary research will gain an edge. I wouldn’t expect the basic ESG screeners that a lot of funds use to generate much of an edge.

Getting back to how to make a difference with investing, I think investors are pretty limited here. The main drivers of positive change are going to be coming from consumer behavior and from government regulations, not so much from investors. Despite this, I do think investors can have some impact, albeit a significantly smaller impact than what’s advertised. I think there are three ways to make an impact. The first would be by buying the debt issuances of companies that are making a difference. When you buy the bonds a company issues, you are giving money directly to that company to support their initiatives. The second way to make an impact is a little counterintuitive, but it would be to buy shares of companies that you want to change. As a form of shareholder activism, you can vote for new board members and policy changes. Some ESG-oriented investment firms are taking this approach. The third way to make an impact would be to invest in companies before they go public. There are a lot of hurdles to doing this, but this is one of the best ways to support initiatives you’re passionate about.

As I think about the future of ESG investing, it is likely to be a very different environment several years from now than what we have today. Much of what is happening in this space today would be considered greenwashing, but I would expect a lot of that to dissipate in the coming years as transparency improves and as investors become more savvy about this space.

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