April 25, 2022
Changing the world for the better is an admirable idea. But doing it through your investment portfolio? Not so much.
Despite what the marketing hype says, the growing number of investment funds that proclaim a higher moral purpose are doing little that will actually promote virtue.
The most obvious problem with the environmental, social and governance (ESG) movement, is that it is difficult to define who is virtuous and who isn’t. Different rating schemes yield very different results, especially as circumstances shift. Energy and defence companies that appeared questionable in January suddenly became bulwarks of our freedom after Russian troops surged into Ukraine in February.
But that’s just the beginning of the challenge. Even if you could somehow define virtue with micrometre-like precision, ESG-oriented investment funds are a feeble way to encourage it.
The fundamental problem these funds face is that buying or selling shares in a business does nothing to affect the sales or the profits of that business. Refusing to invest in a tobacco company, a weapons manufacturer or a coal miner doesn’t change how many cigarettes, guns or tons of coal these enterprises sell or at what prices.
At best, refusing to invest in these companies may bump up their cost of raising capital. But any effect is likely to be marginal. So long as the business is making money, other less scrupulous investors will be happy to rush in and supply the capital you’re not.
The problems with using your investment portfolio as a vehicle for social change have always been obvious, but relentless marketing has done its best to obscure the issues. Now there are signs of a backlash as some prominent observers express their feelings more clearly.
Consider Aswath Damodaran, a professor of finance at New York University and widely followed authority on stock valuation. He has sparred with ESG advocates for a couple of years and last month took off the gloves.
“I believe that ESG is, at its core, a feel-good scam that is enriching consultants, measurement services and fund managers, while doing close to nothing for the businesses and investors it claims to help, and even less for society,” he wrote.
Another hard-to-dismiss critic is Tariq Fancy, a Toronto-born money manager and entrepreneur who used to run sustainable investing at BlackRock Inc., the giant money manager. In an essay last year, he described “how my thinking evolved from evangelizing ‘sustainable investing’ for the world’s largest investment firm to decrying it as a dangerous placebo that harms the public interest.”
Critics of ESG investing make similar points but from different perspectives. Prof. Damodaran, for instance, dismisses the notion that ESG investing is a useful way to spot companies that are better run and therefore more likely to generate superior returns in future.
“The empirical evidence that ESG has a positive payoff is weak, at best, and inconclusive, for the most part,” he writes. It is not clear whether “good” companies are more profitable or more profitable companies are able to afford actions that make them look good.
Russia’s brutal invasion of Ukraine throws a particularly harsh light on ESG’s abilities to link virtue and performance. “There is no evidence that Russia-based companies had lower ESG scores than companies without that exposure [to Russia],” Prof. Damodaran writes. He cites a Bloomberg study that estimates ESG funds had US$8.3-billion invested in Russian equities immediately before the invasion. Most of those shares plummeted in value.
For his part, Mr. Fancy argues that ESG investing detracts from real change by encouraging investors to hand off their moral qualms to unelected fund managers. The problem here is that there is no guarantee that fund managers’ hierarchy of issues will match your own. “Do you really want your banker redesigning society?” he asks.
Furthermore, even if a fund manager perfectly represents your personal moral code, buying or selling stocks is an ineffective way to create change.
Mr. Fancy criticizes the “cloudy linguistics” of sustainable investing, which often confuses the effects of 10 per cent of the market not buying a company’s stock with 10 per cent of customers not buying its product. The former doesn’t really matter to the company because other profit-seeking investors will happily own the shares. The latter matters a lot because it directly affects the company’s bottom line.
“Unfortunately, there’s a difference between excusing yourself of something you do not wish to partake in and actively fighting against something you think needs to stop for everyone’s sake,” he writes.
This gets at the heart of the matter. ESG critics such as Prof. Damodaran and Mr. Fancy are not saying we should dismiss moral or social considerations. They just don’t think that tilting portfolios one way or the other is a great way to achieve a better world.
People who want change should shun products of companies they don’t like. They should push for political action. They should donate money to worthy causes. But picking a mutual fund? That isn’t going to accomplish much.
This Globe and Mail article was legally licensed by AdvisorStream.