For the better part of a quarter-century, Wall Street offered investors an opportunity to think — and invest — differently. By dint of what was called “socially responsible investing” (SRI), individuals and institutions were allowed to choose to align their investments with their values. They could sleep at night knowing that their capital was not supporting causes with which they disagreed, morally or politically. The only cost associated with this socially conscious undertaking was a hit to investment returns, which was inevitable but was accepted voluntarily as the price of peace of mind.
Over the last decade or so, however, some of the investors and activists driving SRI grew disillusioned with the project, believing that its voluntary nature prevented it from becoming a powerful force for the sort of changes they now wanted to embrace. The ESG investment movement — which focuses on environmental, social, and corporate governance factors — is slowly but surely replacing traditional SRI, introducing an entirely new methodology as well as an entirely new promise. By jettisoning the passive and “voluntary” nature of social investments, ESG promises that by being active and coercive, it can also be more effective in accomplishing specific political goals.
Moreover, ESG’s advocates claim that it can achieve its aims while also eliminating the key drawback of traditional SRI: the almost inevitable reduction in returns on investment I mentioned above. The only cost that this iteration of “doing well by doing good” will impose on its adherents, they say, will be a few basis points in commissions. What could be better?
Well, quite a lot: RealClearFoundation has recently published an important new report, written by Rupert Darwall, a senior fellow at the foundation, an author of two books on the environmentalism, and a former special adviser to the U.K.’s Chancellor of the Exchequer. The report — titled “Capitalism, Socialism and ESG” — is divided into four parts: an “overview” that “sets out the key claims made for ESG”; a section that examines “ESG’s central claim that it boosts risk-adjusted investment returns”; a brief look at the legal context undergirding the Trump Labor Department’s 2020 rule on fiduciary responsibilities under the ERISA (Employee Retirement Income Security Act); and a final section that places “ESG in the debate on capitalism, stakeholderism, and the trend to corporatism” and thus exposes the antidemocratic nature of the entire ESG enterprise.
Without getting too deep into the weeds, the third and fourth sections of Darwall’s report are excellent, if, perhaps, slightly truncated. His history and explication of the antidemocratic streak running through the ESG movement are informative, insightful, and interesting. As stand-alone articles, they would be well worth the read.
The real gems in this report, however, can be found in the first two sections. Darwall offers a meticulous, erudite, and, yes, entertaining dissection of ESG, using both theory and evidence. The entire foundation of ESG-investing is built on the notion that the usurpation of shareholder rights is justified because doing so will both save the world and produce equivalent — if not superior — returns to more traditionally oriented investments. As a foundation goes, it’s not the best. Darwall notes:
Advocates of ESG delivering superior investment performance (“risk/return ESG”) must assume that the stock market doesn’t behave as modern finance theory suggests it will. It is not sufficient merely to assert, as Al Gore does, that companies incorporating ESG considerations into their business are more profitable. Proponents of risk/return ESG conflate “evidence of a relationship between an ESG factor and firm performance with evidence that such a relationship, if it exists, can be exploited by an investor for profit,” argue law professors Schanzenbach and Sitkoff in a 2020 paper.
For the risk/return ESG hypothesis to hold, it is necessary that the stock market systematically fails to fully incorporate information on this superior performance into stock prices.
To put it another way, for the ESG proposition to be credible, we must first suppose: (a) that positive returns are not just related to but caused by ESG factors and (b) that these factors would remain unidentified without ESG research methodologies. But common sense, investment theory, and the evidence suggest that this is unlikely to be the case. And Darwall is hardly alone in noticing.
In a recently released paper, Scientific Beta, a “smart” index-platform provider, analyzed the data and concluded that ESG does not provide unique investment insights and that ESG strategies’ out-performance, where it exists, is the result of firm performance overall, rather than ESG-specific factors. The report, titled “Honey, I Shrunk the ESG Alpha,” very much suggests that the risk–return ESG hypothesis does not hold and, indeed, cannot hold [emphasis added]:
We show that there is no solid evidence supporting recent claims that ESG strategies generate outperformance. We construct ESG strategies that have been shown to outperform in popular papers. We assess performance benefits to investors when accounting for sector and factor exposures, downside risk, and attention shifts.
Simple returns of ESG strategies look attractive, with annualised returns of up to almost 3% per year. But when accounting for exposure to standard factors, none of the twelve different strategies we construct to tilt to ESG leaders adds significant outperformance, whether in the US or in developed markets outside the US. 75% of outperformance is due to quality factors that are mechanically constructed from balance sheet information.
ESG strategies do not offer significant downside risk protection either. Accounting for exposure of the strategies to a downside risk factor does not alter the conclusion that there is no value-added beyond implicit exposure to standard factors such as quality. . . .
We conclude that claims of positive alpha in popular industry publications are not valid because the analysis underlying these claims is flawed.
Likewise, Aaron Brown, a former managing director at AQR Capital and a current Bloomberg columnist, dug through some data of his own and noted in May that the only thing that ESG strategies tend to increase is the cost of management to investors:
Want to align the core of your investment strategy with climate-change values? Or build a sustainable equity portfolio for the long-term by focusing on environmental, social and governance goals? A variety of ESG exchange-traded funds have made these and other promises. But as the table below shows, they mostly hold the same large capitalization technology stocks as the S&P 500 Index, represented in the top row by a popular ETF with a minuscule 0.03% expense ratio, in similar weights.
Not only are the portfolios similar, but performance is nearly identical. The Vanguard ESG fund has a 0.9974 correlation to the S&P 500 fund since inception in September 2018, which is higher than most index funds have to their benchmarks. A correlation of 1 would mean the two funds run perfectly in sync.
Instead of putting $10,000 in the Vanguard fund, you could put $9,948 in the S&P 500 fund, and $52 in a long/short fund that bought a bit more of some stocks and shorted small amounts of others so the combination of the two funds had precisely the same holdings as the Vanguard ESG fund. The ESG fund charges $12 per year in expenses, while the index fund charges $3. The extra $9 in fees is really paying for the $52 “active share” fund, an annual expense ratio of over 17%!
The other ESG funds charge similar outrageous fees for tiny adjustments to the S&P 500. FlexShares charges 0.32%, which works out to 16% on the active portion of its portfolio. Conscious Companies charges 0.43%, but has a lower S&P 500 correlation, so is a relative bargain at only 11% for its active portion. SPDR charges 0.20%, or 18% on the active portion. ESG Aware is the second cheapest on raw fees at 0.15%, but its sky-high correlation of performance with the S&P 500 means you’re paying more than 20% on the active share.
Darwall, for his part, goes on to explain why the exclusion of “sin stocks” tends to lower portfolio returns; why the supposed COVID-induced flight to ESG is based on poorly constructed analyses; why the Biden administration’s decision not to enforce the Trump Labor Department’s ERISA fiduciary caveat regarding ESG sets a bad precedent; and finally, why the promise that ESG investing can save the world is both mistaken and antidemocratic.
With respect to this final point, Darwall’s report and broader sentiment are supported by observers as disparate as Tariq Fancy, the former chief investment officer for sustainability at BlackRock and an ESG pioneer, who argued in April that “using vague ESG information alone as a mechanism of change is disastrous. . . . It doesn’t work and creates a giant societal placebo where we think that we’re making progress even though we’re not”; and yours truly, who, in my recently released book, The Dictatorship of Woke Capital, declared that “woke capital” is “the top-down, antidemocratic means by which some of the most powerful and best-known men and women in American business are endeavoring to change capitalism, the securities markets, and the fundamental relationship between the state and its citizens—and to ‘save’ the world.”
In “Capitalism, Socialism and ESG,” Rupert Darwall does the investment world and society at large an enormous service. By putting the arguments underpinning ESG in context and all in the same place, he is able to demonstrate that the entire idea is both fancifully constructed and disingenuously practiced. The fact that his analysis supports — and is supported by — a growing body of research speaks not just to the accuracy of his case but to its timeliness as well. Darwall’s report makes the right arguments at the right time.