What is "ESG investing"?

...and why are some people outraged over it?

Last week, 18 states (surprisingly, Indiana is not one of them… yet) wrote a joint statement pushing back against an “ESG investment agenda.” Here’s a quote from that statement reproduced in an article from The Hill:

“The proliferation of ESG throughout America is a direct threat to the American economy, individual economic freedom, and our way of life, putting investment decisions in the hands of the woke mob to bypass the ballot box and inject political ideology into investment decisions, corporate governance, and the everyday economy.”

“ESG investing” is becoming an increasingly popular hot-button issue. When Telsa lost it’s place on the S&P 500 ESG Index, Elon Musk Tweeted that “ESG is a scam.” Interestingly, he never expressed this opinion back when Tesla was benefiting from being on the list.

The motivation for talking about “ESG investing” today is an opinion published in the Wall Street Journal titled “Is ESG Profitable? The Numbers Don’t Lie” in which the authors condemn ESG investing as “woke capitalism” and conclude that “corporations that remain neutral on social and political issues outperform companies that lean left.” They provide evidence which they (incorrectly) claim shows ESG investing under-performs the market. I’d like to use this opinion piece as motivation to explain two things:

1. What is “ESG investing?”

2. Why the analysis used in the WSJ opinion piece to claim ESG investing under-performs the market is, frankly, crap.

1. What is “ESG investing?”

“ESG” stands for “Environmental, Social and Governance” while “ESG investing” refers to investment in firms who allocate resources towards ESG issues. This type of investing is also often called sustainable investing, responsible investing, impact investing, or socially responsible investing. The Investopedia definition of ESG is:

Environmental, social, and governance (ESG) investing refers to a set of standards for a company’s behavior used by socially conscious investors to screen potential investments.

while

ESG investors seek to ensure the companies they fund are responsible stewards of the environment, good corporate citizens, and are led by accountable managers.

While there is not a single standard way of measuring “ESG” (though there are calls to create one), major brokerages and investment management companies have developed detailed criteria for what they consider ESG. These criteria, which are “set by analysts who identify the relevant issues facing specific sectors, industries, and companies” (again from Investopedia), are generally taken as a kind of standard by investors.

For example, Trillium Asset Management has an extensive description of what constitutes ESG in their funds. Their criteria includes things like “limits harmful pollutants and chemicals” (Environment), “pays employees fair wage” (Social), and “dedicated to corporate transparency” (Government). You can read more Trillium’s ESG criteria here. Or you can read about how the investment management company Blackrock (one of the first to develop ESG investment options) defines Sustainable/ESG investing.

Even S&P has it’s own ESG Index fund (you can read about the methodology here) and offers a standardized ESG evaluation service.

The important thing to remember is that while “ESG” does not necessarily mean exactly the same thing for different investment management firms, there are well-established and detailed definitions of the term which reflect a wide variety of criteria measuring the sustainability and efficiency of firms. “ESG investing” does NOT simply mean investing in firms which take a particular social/political stance.

2. Is ESG investing a bad investment?

The main motivation behind ESG investing is that it encourages sustainability and efficiency investment which support long-term public and social benefits, such as reducing pollution, fighting climate change, and promoting equality and transparency. However, I can understand how these issues may be controversial to some, so, for the sake of the argument, let’s completely ignore those potential benefits and focus purely on the financial benefits of ESG investing. Let’s call this the “Nyah nyah nyah, I’m not doing anything unless it makes me money” view. Even with this very basic and shallow view on investing, the claims that ESG investment is a bad investment falls apart.

In the WSJ opinion piece I mentioned above (“Is ESG Profitable? The Numbers Don’t Lie”) the authors claim to provide evidence showing ESG investing under-performs the market average, however, their analysis has at least one major flaw. Instead of using one of the definitions of ESG developed by investment management companies and actually used by investors, they make up their own arbitrary definition of what ESG means to them. They create a portfolio of stocks using ranking of companies based on “six social/political issues - the environment, education, abortion, Second Amendment rights, other basic constitutional freedoms and support for a safe civil society.” They then show how this portfolio of stocks under-performs the S&P 500 during a very short and specific period of time, the 18 months between Jun. 2021 to Jan. 2023.

Let me repeat that: The “ESG investment” portfolio they construct and measure the returns for is not based on any definition of “ESG” used by the investors or the market, but reflects their own grouping of companies based on arbitrary social/political issues. Not a single dollar has ever been invested (or ever will be) in the portfolio they make up. This approach is ridiculous given there are hundreds of well-established ESG investment funds and portfolios which investors are actively investing in based on detailed definitions of ESG. Why invent your own criteria for defining ESG when many well-established standards already exist? My guess why is that the results using standard ESG definitions aren’t consistent with their narrative. When you look at the returns to ESG investing based on definitions of ESG which are actually being used, their claims fall apart and it’s easy to see why ESG investing has become popular purely for financial reasons.

Let’s take as an example one of the largest, most popular and well-established ESG exchange-traded fund (ETF) from a non-specialized investment management company, BlackRock’s iShares ESG Aware MSCI USA ETF (ESGU). This fund has consistently out-performed the market, as measured by the S&P 500. The table below shows the annualized return of ESGU versus the S&P 500 for the last two years (Jan. 2020 to the present) and since the fund was first created (Dec. 2016 to the present). For both time periods, ESGU outperformed the S&P 500 by a significant margin, +1.4%/year more recently and +2.1%/year since it was created.

Why are these returns so different than what the WSJ opinion piece finds? Well, when you make up you own interpretation of what “ESG” means and then cherry pick firms to include based on your of definition of their level of “wokeness” you can pretty much skew the results however you want.

Of course, the returns I highlight above reflect only a single fund. While the concept of ESG investing is relatively new, there is a growing literature showing ESG investing performs comparably with, if not outperforms, average market returns. Below are links to a few of these studies:

• In 2021, an NBER published a working paper (Dissecting Green Returns) found that between 2012 and 2020, U.S. stocks with high ESG ratings outperformed those with low ratings (by as much as 35%).

• In 2020, a report published by NYU looked at over 1,000 studies on ESG and performance and found a positive correlation between the two.

• In 2020, research done by Morningstar and reported in the Financial Times (“Majority of ESG funds outperform wider market over 10 years”) found that ESG funds outperform non-ESG funds in long-term performance. They also find that ESG funds are more likely to survive longer than non-ESG ones.

• In 2019, a report by Morgan Stanley found that “there is no financial trade-off in the returns of sustainable funds compared to traditional funds, and they demonstrate lower downside risk” (i.e. similar return but for lower risk).

• In 2015, a Harvard Business School study found that firms with higher investment in material sustainability issues (i.e. ESG issues) significantly outperform firms with lower investment.

These studies are just a small selection. There are many more.

3. The bottom line

The WSJ opinion ends with the following sentence:

“The data indicate that, as common sense would suggest, companies that focus on profits outperform companies that don’t.”

The idea that “profits” are the only thing matters in investment is naive and a common misconception about Economics. Investors and shareholders care about the market value of their investments, and the growth in that market value. While profits certainly affect market value, they are not the only aspect that matters. Market value is ultimately driven by what consumers and investors value. If consumers and investors care about ESG issues, which today they overwhelmingly do and in the future will likely care more, then when firms allocate assets to ESG issues this will be reflected in the market value.

Sadly, “ESG investing” is simply the latest example of a concept being misrepresented, hijacked, and turned into a buzzword to generate false outrage. It joins an array of acronyms like CRT, BLM, SEL, which mean something very different than what the talking heads want you to think they mean. If there is outrage to be had here, it should be over the pundits and politicians trying to mislead you about ESG.