Here Come the ESG Boo Birds
Call it what you will – ESG, socially responsible, sustainable – values-based investing has become as polarizing as seemingly every other topic in American society.
On the one hand, the current administration seems intent on incorporating it into every nook and cranny of financial, monetary and regulatory policy. On the other, ESG "boo birds" have recently come out in force, pushing back on the rush to invest in investment strategies that stake a claim to being socially responsible.
A recent Wall Street Journal op-ed titled "Who Really Pays for ESG Investing?" claims, "If ESG investing truly maximized returns, fund managers wouldn't fake a commitment to it while quietly doing their job – investing in companies that focus on shareholder returns and profits."
A recently published study by Scientific Beta, "Honey I Shrunk the ESG Alpha," argues there is no positive ESG alpha and states, "ESG strategies perform like simple quality strategies mechanistically constructed from accounting ratios."
Blackrock's former sustainability investing CIO accused financial services firms in a USA Today op-ed of greenwashing in the name of profits.
Even my Baird colleague Jason Trennert at Strategas (et tu, Jason?), pointing to a 98% correlation between the risk/return profile of the leading ESG ETF and that of the S&P 500 Index (with almost identical sector weights), writes, "Products being sold to achieve these social goals are little different from the Broader Index itself, merely more expensive."
It's no surprise that as socially responsible investing enters adolescence here in the United States, it is coming under increased scrutiny and losing some of its youthful luster. Some of the criticism is deserved. This is yet another area where the financial services industry has taken a good idea and pushed it to commercial excess. There is a lack of consistency around metrics. Product sponsors have made unsupportable performance claims based on short-term one-year results post-COVID. Not to mention that the language of socially responsible investing is enough to confuse even experienced investors.
However, what underlies much of the criticism of ESG is a failure to acknowledge a sea change in what it means to be a fiduciary.
Fiduciary traditionalists believe that the sole responsibility of individuals, firms and committees managing and overseeing portfolios is investment return – more specifically, risk-adjusted returns over full market cycles. I can remember being chastised by committee elders on one of my first committee assignments 35 years ago for failing to hew to the investment management equivalent of Milton Friedman's pronouncement that the only responsibility of corporate executives is to grow shareholder value.
Friedman's shareholder-centric formulation has been since been replaced by the Business Roundtable's 2019 statement about stakeholder value, which declared that corporate executives are accountable to multiple consistencies – shareholders, yes, but also employees, customers and clients, suppliers and the communities in which they all live and work.
In the same way, the orthodox view of fiduciary duty is being replaced by a more holistic vision of what it means to be a fiduciary: one in which fiduciaries are responsible not just for investment returns, but for the overall well-being of the ultimate beneficiaries of the funds they are overseeing.
It doesn't do any good to beat one's benchmark or generate a superior Sharpe ratio if, in the process, the planet can't support life or social order devolves in the face of economic inequality.
Or, as an "Other Voices" column in Barron's recently suggested, it is penny-wise and pound-foolish to focus on portfolio diversification while ignoring "real-world root causes of systemic risk" that can't be diversified away but determine more than 75% of your return.
No less a traditionalist organization than the CFA Institute – known for ethical integrity and analytical rigor in support of the investment profession – has embraced "purposeful capitalism." The Institute's 2021 report, entitled "Future of Sustainability in Investment Management," embraces "a mindset change" that calls on investment organizations to "be proactive, rather than reactive, in helping solve the world's problems."
"Financial organizations must ... combine their financial views with some exposure to wider stakeholders," the report states, and must consider "total system-wide returns on capital."
Which, one might agree, is a dramatically broader mandate than mere investment returns alone – and one ESG boo birds may want to consider before decrying socially responsible investing strategies.
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