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Does ESG Investing Really Work? – The White Coat Investor – Investing & Personal Finance for Doctors


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I’m getting more and more questions about the various methods of investing that consider non-financial factors. If that sounds vague, it is. That’s because there is a whole industry out there trying to figure this all out and the goalposts keep changing.

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Socially Responsible Investing

First, there was SRI — Socially Responsible Investing. This is generally defined as investing in a business that is considered socially responsible due to the nature of the business the company conducts. If that sounds vague, let me break it down for you. “Socially responsible” is in the eye of the beholder. For example, someone on the left side of the political spectrum may view a gun manufacturer or a defense company as socially irresponsible. Someone on the right side of the political spectrum may view those same companies as socially responsible because they promote the second amendment and provide for the common defense.

Some people may view drinking alcohol as sinful, and oppose any company that produces alcoholic drinks. Others may view craft beer as a fantastic hobby and part of a well-lived life. Perhaps Investopedia says it best when it says “Socially responsible investments tend to mimic the political and social climate of the time.” It kind of reminds me of the delay we’re seeing with the TSP moving from a developed market index to a total international (including emerging markets) index for its International fund because the government doesn’t want to invest in companies based in a country (China) with whom it is having a trade war.

Sustainable Investing

Next came “Sustainable investing.” This was the process of directing investment capital to companies “that seek to combat climate change and environmental destruction while promoting corporate responsibility.”

Impact Investing

Then came “Impact investing.” These are investments “made into companies, organizations, and funds with the intention to generate a measurable, beneficial social or environmental impact alongside a financial return.”

Environmental, Social, and Governance Investing

Finally, we arrive at ESG – Environmental, Social, and Governance investing. Now we want the companies we invest in to protect the environment, promote our favorite social causes, and ensure good corporate governance.

I find it very interesting to see Governance thrown into the mix. While there are lots of interesting debates about what is environmentally friendly and what is socially good, every investor wants to see their company governed well. Per Alyce Lomax and John Rotonti, some of the governance factors that a fund might look at include:

  • Executive compensation, bonuses, and perks.
  • Compensation tied to metrics that drive long-term business value, not short-term EPS growth.
  • Whether executives are entitled to golden parachutes (huge bonuses upon exit).
  • Diversity of the board of directors and management team.
  • Board of director composition regarding independence and interlocking directorates — which can indicate conflicts of interest.
  • Proxy access.
  • Whether a company has a classified board of directors.
  • Whether chairman and CEO roles are separate.

  • Majority vs. plurality voting for directors.
  • Dual- or multiple-class stock structures.
  • Transparency in communicating with shareholders, and history of lawsuits brought by shareholders.
  • Relationship and history with the U.S. Securities and Exchange Commission (SEC) and other regulatory bodies.

Those all seem like pretty good things to have, right? The better a company is run, the more profitable it ought to be, no? In fact, that’s the case that Kofi Annan made when ESG investing was born back in 2004. Forbes described it this way:

Today, ESG investing is estimated at over $20 trillion in AUM or around a quarter of all professionally managed assets around the world, and its rapid growth builds on the Socially Responsible Investment (SRI) movement that has been around much longer. But unlike SRI, which is based on ethical and moral criteria and uses mostly negative screens, such as not investing in alcohol, tobacco or firearms, ESG investing is based on the assumption that ESG factors have financial relevance.

So the theory is that if a company pays attention to ESG “stuff”, it’ll be a better, more profitable company.

Does ESG Investing Work?

Before deciding to invest only in companies with high ESG scores (however those may be defined), your first consideration should be “Does it work?” And what I mean by that is two things:

  1. Does this investment actually improve the planet and the people on it?
  2. Does this investment actually meet my financial goals?

I suspect there is yet another reason that people invest in ESG funds/ETFs/stocks etc. Status. Rather than bragging about high returns at cocktail parties, you can demonstrate how environmentally and socially conscious you are. But I’m going to ignore that for now and assume that people only care about the first two questions.

Does ESG Actually Change the Way Corporations Are Run?

The owners of a business certainly have an effect on how a business is run. For example, as the owners of WCI, LLC, Katie and I get to decide how much rainforest land our company cuts down for its new headquarters. We get to decide whether to partner with Phillip Morris to promote the Marlboro brand. In the same way, the owners of a large, publicly-traded corporation can decide how it behaves. However, your effect on that corporation is somewhat diluted.

esg investingFor example, there are over 5 billion shares of Apple stock. Tim Cook owns a whole bunch of them, but less than a million. He owns less than 1/50th of 1% of them. If you want to affect the way Apple runs its business, you’re going to need to organize a lot of people to do it. Even a monstrous mutual fund such as the Vanguard Total Stock Market Index Fund has just 3.5% of its money in Apple. 3.5% of $875 Billion = $30.6 Billion. At $300/share, Vanguard TSM shareholders own approximately 102 million shares, or less than 2% of the company. Now that’s a lot more than Tim Cook owns, but it’s still nowhere near enough that your votes can somehow change the way the company operates.

I couldn’t find any data out there suggesting that the fact that some investors take this approach actually changes how companies behave. So I decided to look for anecdotes. Janet Brown claims that

Investors filed more than 400 proposals just on environmental and social issues in 2015 alone, according to the U.S. Forum on Sustainable Investing….Investors have persuaded hundreds of companies to make significant improvements. For instance, Domini Impact Investments encouraged Target to reduce the use of toxic PVC plastic in children’s products. As a result, Target today has a sustainable product standard that scores thousands of products based on toxicity. Other major retailers, like Walmart and Sears, soon followed suit…. Trillium Asset Management engaged with Home Depot, which was one of the world’s largest retailers of old-growth lumber at the time….Home Depot agreed to use more sustainably sourced wood, and by 2009, Home Depot had sold more Forest Stewardship Council-certified wood than any other company in North America.

So there are definitely some anecdotes out there. Maybe there would more anecdotes or even data if the funds that claimed to be following an ESG strategy were actually doing so. Consider this article in Barrons/WSJ showing that 8 out of the top 10 largest ESG funds invest in oil and gas companies:

For instance, BlackRock (BLK) says its iShares ESG MSCI USA ETF aims to track an index of companies with “positive environmental, social and governance characteristics.” The fund includes Exxon Mobil (XOM), which is awaiting a ruling in a trial involving allegations that it misled investors about how it accounted for climate-change regulations. A spokesperson for the oil giant says the allegations in the lawsuit are baseless.

Vanguard Group’s FTSE Social Index Fund is meant to track an index excluding companies with “significant controversies regarding environmental pollution or severe damage to ecosystems.” Both that fund and another large ESG fund operated by Xtrackers include Occidental Petroleum (OXY), which in 2015 paid Peruvian indigenous villagers an undisclosed sum to settle a suit accusing it of contaminating the Amazon.

Apparently, not only do investors need to choose mutual funds that will monitor companies for their ESG activities but also have to actually monitor the mutual funds themselves to make sure they’re doing it.

At any rate, forgive me for being skeptical that investing in an ESG fund is actually changing the world for the better. It shouldn’t be a big surprise. When you buy a share of stock from the person who owned it before, the company doesn’t get any money. It goes from your pocket to the prior investor’s pocket. All it entitles you to is one tiny little vote and your tiny little share of the profits. When you buy a share of Occidental Petroleum, you’re not funding the exploitation of Peruvians. That funding was all done before the company went public in 1978. Maybe a really tanking stock price will affect what the C suite does because they want to do well on their stock options, but given that there will always be investors who care more about profits than ESG stuff, it’s going to be really hard to drop a stock price hard enough to change corporate behavior just from investor pressure. You’d probably be better off organizing a huge boycott of a company’s products than trying to round up enough shareholders to change the direction of the company. The end result of good people avoiding the purchase of bad companies is that the bad companies will be owned by bad people who don’t care about the stuff the good people care about.

Do ESG Investments Provide Good Returns?

Let’s turn now to the other big question. If, for some crazy reason, you think ESG investing actually works, can you still do well while doing good? If not, how much money will it really cost you to try? Let’s take a look at some popular ESG funds.

Another article by John and Alyce suggests that stocks with good ESG scores may actually outperform the overall market. If that’s true, everyone ought to be interested in an ESG fund, no? Let’s go to the ticker.

According to Morningstar, in 2018 63% of ESG funds were in the top half of the funds in their category (58% over 5 years). That’s not exactly saying much though. Consider the Vanguard Total Stock Market Fund. It beat 58% of its peers in 2019 and 74% of its peers over the preceding 5 years and 86% of its peers over the preceding 10 years.

At the end of the day, ESG funds are generally actively managed mutual funds and as those who have been reading this blog (and pretty much everyone else’s and any halfway decent investment book and talking to anyone who knows what they’re talking about) investing in actively managed mutual funds is almost a guarantee of long term underperformance. Now there are some “ESG Index Funds” and “ESG ETFs” but given the subjectivity of these screens I think the description of these as “index funds” is more marketing than descriptive.

If you’re going to invest in an ESG Fund or ETF, where are you likely to start looking? Why not with the usual default choice, the low-cost leader Vanguard? They’ve got an ESG ETF, with a slick ticker ESGV and a very low expense ratio of 12 basis points. How is it doing? Well, it’s Morningstar X-ray looks almost exactly like the Total Stock Market ETF VTI, so that seems a reasonable comparison. It hasn’t been around very long, so we only have one year of returns to look at, 2019. In that year ESGV returned 33.37%. VTI returned 30.67%.

So while the jury is still out, it appears to me that it is entirely possible to get adequate, and perhaps even better, returns using an ESG strategy so long as you follow the other principles of investing — diversification, keep costs low, use a passive approach, etc.

The Bottom Line on ESG Investing

If you wish to try ESG investing, at a minimum you will get some status and bragging rights at cocktail parties. You may have some limited impact on the behavior of some corporations. You may do just as well or even better than index funds. On the other hand, perhaps this is a fad, and fickle investors will turn their back on it soon, and there will be a return to the mean as there often is in investing. Perhaps the prices of companies with good ESG scores are being bid up by the creation of all these ESG funds and future performance will be worse. Maybe the luck of VICEX, a fund that tilts toward “sin stocks” like alcohol, tobacco, firearms, and defense companies is about to change (2018-2019 returns were terrible, but it was a top performer in 2011-2012). An awful lot of the information on ESG investing out there feels to me like marketing from fund managers that I have seen time and time again with dozens of different investing strategies. I don’t plan to tilt my portfolio toward ESG stocks, personally.

Perhaps the most important principle in investing is to get a good financial plan and stay the course with it through thick and thin. If you still need a financial plan, I created Fire Your Financial Advisor! A Step by Step Guide to Creating Your Own Financial Plan so you can quickly and easily get a good one in place.

My plan has me investing primarily in broad-based, traditional index funds, and I plan to stay the course. We will use the money we make to support good causes. I suggest you do the same–pick a reasonable plan, stick with it, and support good causes, whether or not it involves ESG investing.

If you do go down the ESG road, at least read the fund prospectus to make sure the view of the fund manager on what is responsible or sustainable is the same as your view. For example, here is the description of “good” that the Vanguard ETF uses:

The FTSE US All Cap Choice Index excludes stocks of companies that FTSE Group (FTSE) determines engage in the following activities:

  • (i) companies that produce adult entertainment;
  • (ii) companies that produce alcoholic beverages;
  • (iii) companies that produce tobacco products;
  • (iv) companies that produce (or produce specific and critical parts or services for) nuclear weapon systems, chemical or biological weapons, cluster munitions, and anti-personnel mines;
  • (v) companies that produce other weapons for military use;
  • (vi) companies that produce firearms or ammunition for non-military use;
  • (vii) companies that own proved or probable reserves in coal, oil, or gas;
  • (viii) companies that provide gambling services; and
  • (ix) companies that generate revenues from nuclear power production.

The index methodology also excludes the stocks of companies that, as FTSE Group determines, do not meet the labor, human rights, environmental, and anticorruption standards as defined by the United Nations Global Compact Principles, as well as companies that do not meet certain diversity criteria.

So if you’re just fine with companies that dam up rivers and kill salmon, or chop up birds with giant windmills, or support the exploitation of Chinese minorities by purchasing solar panels made up of rare metals mined in China, but against companies that generate clean nuclear power and defend America from our enemies, this one is for you! But if you like hunting, craft beer, drone strikes on terrorists, and trips to Vegas, you probably need to keep looking.

What do you think? Do you use ESG principles to invest? How? How did you choose a fund or index to support? Do you feel like you’re making a difference? How is the performance? How much performance would you be willing to give up in order to invest in this way? Comment below!


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