Study on strong ESG performance yields a disturbing conclusion

Forget other metrics, your ranking might just be based on how many employees you have

Above, It isn’t easy being green: Works assemble Magnavox TVs in an Indiana factory.

(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) — Recent research sheds light on why ESG investing is such a hard sell in some quarters of our society.

It turns out that the companies most favored by ESG rating organizations tend to be those with the fewest employees.

That is the surprising — and disturbing — conclusion of a study conducted by Vincent Deluard, head of global macro strategy at investment firm StoneX. Deluard says that he initiated his study to find out why the average ESG fund has so outperformed the market so far this year. He thought he would find the answer in the various style, sector and industry bets that ESG funds make relative to the overall market.

That’s when he says that he “accidentally stumbled upon a much larger and problematic feature of ESG ETFs: ESG criteria effectively screen out companies with a lot of employees!” Deluard emphasizes furthermore that this tendency “dwarfs” all the other style, sector and style bets that these ESG funds are making: “The average company in the ESG basket has 20% fewer employees than” the median company in the Russell 3000 index.

To be sure, this ESG bias is unintentional, as Deluard is quick to emphasize.

Ideologically, ESG investing is motivated by the admirable social impulse of making the world a better place. Its adherents will be horrified to learn that an unwitting effect of their approach is to shun companies with the most employees.

At the same time, however, this bias against employee-heavy companies is not accidental but “structural,” Deluard said in an email. “It is much harder for companies with a big physical footprint (mining, hotels, car manufacturers) to score highly on ESG criteria than it is for tech platforms, payment networks, or biotech firms, which have almost no carbon footprint, very few employees to worry about, and the time to focus on governance issues.”

Consider biotech company Vertex Pharmaceutical (VRTX), which sports a market cap-to-employee ratio of $25 million, one of the highest among publicly-traded companies. According to Sustainalytics, one of the leading global firms that provides ESG ratings (and which recently became part of Morningstar), Vertex has a more favorable environmental risk score than 448 of the companies within the S&P 500.

This is exactly what we should expect, according to Deluard: “Biotech labs where a handful of PhDs strive to find the next blockbuster molecule have no carbon footprint.”

In contrast, consider American Airlines (AAL), which has one of the lowest market-cap-to-employee ratios among publicly traded companies, at just $38,000. That’s just 0.15% as much as Vertex’s ratio. Yet American also employs 45 times more people as Vertex.

American has a very unfavorable environmental risk score from Sustainalytics: More than 400 of the S&P 500 companies have more favorable scores, in fact.

Once we view ESG investing through this employment lens, it becomes obvious why there is widespread antipathy to ESG values among some in our society.

Is there a way to promote ESG values while also supporting companies that employ the most people? It won’t be easy, since it will involve hard trade-offs. As Deluard argued in an email, it requires recognizing that “providing jobs to a lot of people, especially to low-qualified workers, produces positive side effects for society — a thriving middle class, less drug abuse, healthcare coverage of employees etc. — which are at least as valuable as some of the original goals of the ESG movement.”

Of course, in light of the potential environmental disasters that loom from climate change, the social consequences of unemployment may seem a lower priority. But that attitude is dangerous from a political, social and cultural perspective, since it contributes to the perception that environmental sustainability is an elite, upper-class goal.

This perception has become even more exaggerated because of the Covid-19 pandemic. Quarantines and shelter-in-place orders have had relatively little impact on companies with few employees, and on average their stocks have far outperformed the market. In contrast, most companies with lots of employees have suffered in the wake of those shelter-in-place requirements.

If we want to have a real chance of realizing our ESG goals, then we need to broaden the movement. We have our work cut out for us.