Category: ETFs and Funds

Typical ESG investing (aka socially responsible investing, SRI investing, responsible investing, etc.) is a waste of time. It doesn’t achieve what many hope and believe.

Instead, many ESG funds only serve to pacify anxious investors who wish to decorate their portfolios with feel-good products. It’s sad to say because both ESG investment product manufacturers and investors usually have the best intentions. They want to do the right thing. Unfortunately, many fail to recognize their efforts are probably counterproductive and likely worsen the issues they are meant to fight.

As global interest in ESG investing rapidly grows, it is critical that investors understand how many ESG investment funds fall short of their implied objectives.

What is an ESG fund?

ESG funds are investment products (like mutual funds or exchange traded funds) that are constructed to feature environmental, social and corporates governance factors into their investment process.

Many ESG investment funds attempt to do this by excluding certain categories of sin stocks: guns, tobacco, porn, and so on. With growing concern about climate change, oil is increasingly at the top of the sin list.

The first problem with oil company exclusion is it’s very limited in scope. Oil companies don’t operate in a vacuum and are highly integrated within all sectors of the economy. They are financed by banks. They supply petroleum to chemicals and plastics manufacturers. Plastics are used in the production of millions of products. If boycotting oil companies, why not also their best customers and financiers?

It’s true that oil companies are at the heart of CO2 emissions and shutting down oil companies would stop the flow of petroleum based products throughout the economy. But excluding oil companies from ESG portfolios fails to shut anything down.

Companies have always had to work with various strata of investors who exclude certain investments based on a variety of characteristics. Value investors shun momentum stocks. Most of the world doesn’t invest in Canadian companies. Tobacco and gun stocks have been excluded from many large portfolios for decades. Yet, tobacco stocks, gun stocks and Canadian stocks have continued to perform as expected. Altria (formerly Phillip Morris) has a stellar long-run track record.

Is ESG investing profitable?

The exclusion of companies or sectors doesn’t affect performance. Research from South Africa’s period of Apartheid has shown that boycotting certain companies, sectors or countries is ineffective at altering share price performance.

Companies simply don’t need 100% of investors to be interested in their stock. There will always be a class of investors who don’t care about what they invest in as long as the returns are good.

In fact, the exclusion of certain companies from ESG portfolios may actually improve return prospects for those excluded companies. Perversely, if 80% of investors shunned Altria, for example, causing its share price to decline Altria’s expected future return would rise, attracting the remaining 20% of investors. A smaller pool of potential investors doesn’t change a company’s business prospects, and thus its intrinsic value. There will always be investors willing to capitalize on this. Moreover, without the burden of ESG-related business expenses, Altria’s intrinsic value may actually rise relative to other ESG-friendly companies.

Does ESG investing make a difference?

As conscientious investors abandon a company, the remaining class of financiers care less-and-less about the company’s practices. All things equal, this leaves the offending company to continue as it pleases, perhaps even creating a disadvantage for the ‘good’ companies that must operate under greater constraints.

Investors looking to force change would do better by adopting methods used by activist investors, like Carl Icahn. Activist investors take large stakes in companies they want to change. Shareholders, as company owners, have a right to board representation. The board hires company executives who then run the company.

To create change, investors must not distance themselves from companies with weak ESG practices. Instead, they must directly engage the companies they wish to change.

Research by the European Corporate Governance Institute shows that shareholder activism can create real change:

We study the nature of and outcomes from coordinated engagements by a prominent international network of long-term shareholders cooperating to influence firms on environmental and social issues. A two-tier engagement strategy, combining lead investors with supporting investors, is effective in successfully achieving the stated engagement goals and is followed by improved target performance. An investor is more likely to lead the collaborative dialogue when the investor’s stake in and exposure to the target firm are higher, and when the target is domestic. Success rates are elevated when lead investors are domestic, and when the investor coalition is capable and influential.

Abstract, “Coordinated Engagements”. January 2021

Given this perspective, ESG scores for investment funds (provided by various rating agencies) can be totally misleading. Based on current methodologies at many ratings agencies, to get a high score a fund must have minimal exposure to offending companies. As shown above, this can have a counterproductive result.

Don’t divest. Engage.

None of this is easy. However, if institutional investors (which represent individual investors) combine efforts and own enough of a company to engage the board they can enact real change. This is not an unusual practice, as investors have banded together many times in the past.

As public concern over climate change grows, there will likely be enough energy to make a real difference. However, it is critical that efforts are directed correctly, away from feel-good ESG products and into activist ESG funds.