How ESG's vague meaning is hurting its investment potential

Lack of a standard definition hasn’t stopped many ESG managers from making breathless claims about the performance

(Mark Hulbert, an author and longtime investment columnist, is the founder of the Hulbert Financial Digest; his Hulbert Ratings audits investment newsletter returns.)

CHAPEL HILL, N.C. (Callaway Climate Insights) — ESG criteria will become meaningless the day they become all things to all people.

I’m afraid that day may have arrived.

Consider the comments a leading ESG fund manager made in a recent webinar when describing his approach to finding highly-rated ESG companies. He said he searched for those high-quality companies that are “most well-attuned” to their clients’ preferences.

That sounds nice, but what does it really mean? I’m hard pressed to think of any company, no matter how big a greenhouse gas emitter, that couldn’t nevertheless claim that it’s well attuned to its client’s preferences. Perhaps this manager had an inkling of the extent to which his approach strips any meaning from ESG, since he went on to say that “maybe there is no difference between high quality and high ESG quality.”

It would be one thing if this manager were an exception. But he’s not, which is why I’m not mentioning him by name. His arguments are worth exploring precisely because his views are so widely shared.

Do ESG funds outperform?

Notice carefully one of the consequences of there being such a wide range of corporate practices that fall under the ESG umbrella: Performance claims about the “average” ESG fund make little sense. Without knowing the particulars of how two ESG funds are applying the ESG criteria, we are likely to be comparing apples to oranges. The devil is in the details.

This, in effect, is the conclusion that Research Affiliates recently reached when exploring whether ESG should be considered a performance factor in the stock market, in the same way that size and value (to name the two most famous) are factors. They concluded that it is not.

“ESG has no common standard definition and is a broad term that encapsulates a range of themes and subthemes ...,” the Research Affiliates’ analysts wrote. “Conducting a quick web search yields several ESG strategies whose underlying themes are quite distinct and different. These index strategies align more closely with investor preferences than with a particular factor.”

This lack of a standard definition hasn’t stopped many ESG managers from making breathless claims about the performance superiority of ESG funds in general. In one webinar on ESG investing I attended a couple of weeks ago, a manager insisted that there is now “conclusive evidence” that an ESG focus leads to better performance. A manager in another webinar claimed that there no longer is “any doubt” that ESG strategies outperform.

I nevertheless have doubt, on both practical and theoretical grounds. 

As a practical matter, it strains credulity to think Wall Street wouldn’t have long ago embraced ESG strategies if they regularly outperformed the market. Wall Street managers are intensely competitive, devoting countless hours and resources to discovering what would give them even a tiny advantage over their competitors. The money managers I speak to assure me that if there were a way of using ESG criteria to reliably and consistently beat the market, everyone on Wall Street would have long since made it a core part of their investment strategies — regardless of whether they believed in mitigating climate change or not.

If you have any doubt about managers’ hyper-competitiveness, read the classic Michael Lewis book Flash Boys. It documents how some trading firms spent millions to get a faster fiber optic connection to the stock exchanges in order to gain a several-millisecond head start over other firms.

There are also good theoretical grounds for doubting the performance claims made for ESG strategies: If our goal is to change corporate behavior, then we must be willing to accept lower rates of return when investing in “good” companies. That’s because our goal has to be increasing the cost of capital for “bad” companies, and as we remember from Finance 101, a stock’s expected future return is equal to its cost of capital.

Take tobacco companies, which have appeared on socially responsible investors’ list of “bad” companies for longer than almost any other industry in the U.S. According to the Credit Suisse Global Investment Returns Yearbook 2020, one dollar invested in the U.S. market in 1900 would have grown to $58,191 by the end of 2019. In contrast, one dollar invested in the tobacco industry grew to more than $8 million.

Socially responsible investors should celebrate this statistic. The difference in these returns — equal to 4.6 annualized percentage points — reflects the degree to which anti-tobacco activists’ efforts increased the industry’s cost of capital. This higher cost of capital meant that tobacco companies were unable to pursue projects that they otherwise would have been able to justify. Far from bemoaning the market’s lower rate of return, we should recognize it as evidence of the activists’ effectiveness.

This is why in recent columns I’ve argued that, as socially responsible investors, we should be willing to accept a below-market return. Otherwise we’re not making any difference, since the companies we would be investing in would be having no difficulty securing just as favorable financing from non-socially-responsible investors.

An autobiographical note

Since I often criticize the rationales that are widely given for investing in ESG funds, I want to stress that I am not against socially responsible investing. I have a major chunk of my retirement funds invested in two well-known ESG funds.

And while both have performed well, I want to stress that I wouldn’t get rid of them if they underperformed the market. If my sole goal were equaling the return of the S&P 500, I would invest in an index fund and be done with it.

But I am hiring these funds’ managers to apply a particular set of social criteria in choosing which companies to invest in. The criteria for judging their success must include not just their investment performance but also whether they helped to nudge companies toward what I think is better behavior. And the only way to provide that nudge is, one way or another, to lower “good” companies’ cost of capital relative to that of “bad” companies.

Investors interested in fighting climate change have been sold a bill of goods that they can have their cake and eat it too. That makes them fair-weather friends of the climate at best, since they are likely to get rid of their ESG funds at the very moment they start to do some real good.