ESG Investing
Environment, Social, Governance (ESG) investing is a sustainable method to simultaneously invest in the stock market and humanity's future. Sustainable in this context addresses both social and environmental concerns. ESG investing is not merely a philanthropic endowment. An underlying assumption is that a company's financial performance is directly affected by social and ecological factors. By investing in ESG-related indices and investment vehicles, prevailing thought holds that you stand to turn a profit. (Innovations) We will examine this assumption further.
While Corporate Social Responsibility (CSR) identifies an organization's overarching values, ESG sets specific criteria to keep businesses honest with the data-based, measurable commitment they have made to sustainable activity. (Group) Ian Kirwan, portfolio manager at Calvert International Equity Fund, shared, "We use ESG as a source of information to hopefully tell us something about the investments we're looking at." (Pippa Stevens)
The vehicles available for ESG investing mimic other standard methods of investing. For example, Vanguard offers the following ESG products: four passively traded products, including three ETFs (International, Bond, Large-Cap Blend) and one Index Fund (benchmarked by FTSE Social). Additionally, they offer two actively managed international mutual funds. The broadcasted distinction between ESG investing and all other investing is not the products offered but the composition of ESG-vetted companies within the ESG product portfolios. But how are companies vetted for being effective within their ESG?
Historically, in the United States, the companies included in ESG-related investment vehicles were left to the portfolio manager's discretion as there is no formal regulation to dictate otherwise. The early stages of ESG investing were a time of inventing, and while benchmarks existed, they did not need to be factored into a product offering. The lack of regulation leads to valid critiques of "greenwashing" as ESG criteria vary across organizations. Companies and investment vehicles that claimed to be "ESG," "Paris-aligned," or "Climate-transition" could make these claims however they chose. It was the wild west of claiming to be sustainable and a very ineffective example of ESG. Further proof of this "hype" is found within the holdings of the largest ESG funds.
Reviewing the Vanguard ESG U.S. Stock ETF (ESGV), we find "about 20.8% of ESGV's assets invested in four tech stocks—Apple Inc., Microsoft Corp., Amazon.com Inc., and Alphabet Inc. By comparison, the S&P 500's weighting in the four leading U.S. technology companies is 20.6%." (Quinson) This is not just a one-off occurrence. The third largest ESG-focused fund is BlackRock Inc.'s iShares MSCI USA ESG Select Social Index ETF (SUSA). Their top three holdings are Alphabet, Apple, and Microsoft, "and (they have) almost one-third of (their) $4.1 billion devoted to tech-related companies." (Quinson) These ESG-related investment vehicles appear to have similar foundational holdings as their non-ESG benchmark counterparts. While they are not duplicate portfolios, they replicate a notable percentage of similar holdings.
Recognizing this lack of transparency, in 2021, the European Commission set requirements, resulting in ESG asset managers accelerating their use of the benchmarking standards created by European authorities. As of July 27, 2021, it was estimated that only $1.2 billion of a $35 trillion ESG assets worldwide met the new benchmarking criteria. (Schwartzkopff)
Today, regulation is aiding in the cleanup of greenwashing and providing transparency to ESG investors. These steps are an excellent example of ESG because the companies that make up an investment vehicle portfolio must meet specific metrics to make an ESG claim. These defined governmental benchmarks mitigate marketing ambiguity and allow investors to make informed decisions. This enhances the ethics surrounding these investments, but it also serves the purpose of ESG- to use data to understand the levels of impact and commitment a company makes concerning the environment, society, and governance.
Does ESG investing outperform the stock market?
Any actively managed mutual fund which beats the market can mostly be attributed to luck. "An incredible 96% of actively managed mutual funds fail to beat the market over any sustained period of time." (Robbins) In case that statistic feels wrong, it is further supported across multiple outlets. AEI.org estimates this figure at 95% (Perry), while Business Insider shares it at 90%. (Rosenberg) For the remainder of this discussion, I will utilize Robbins' figure.
In 2012, Charles Wheelan authored the book "Naked Statistics." Within the read, he shared a lesson on probability, identifying the human error of assuming events are interdependent when they are, in fact, independent. He illustrated this point with a coin-flipping experiment. Within a classroom of his students, he was seeking to find the expert heads-flipper. Beginning with approximately 100 students, probability removed about half after the first flip. Another half after the second. Another half after the third, and so on. In the end, probability tells you that you can expect one person to flip heads eight times in a row. This is what actively managed mutual funds are, a sea of coin flips, with of few "experts" that come out on top at the end. The "expert," in this case, is the fund manager who chooses the proper portfolio composition that beats the market. This is the investment vehicle that the institution will promote to investors. Imagine this process across any sector investment vehicle. So, how have the ESG coin-flippers faired?
Of the 170 ESG funds comprised of U.S. stocks, 73 outperformed the S&P 500 in 2020, 49 in 2021, and as of February 11, 2022, only 40 have outperformed this year's 7% S&P 500 loss. Of the 170 ESG funds, only two have generated positive returns in 2022 as of mid-February. (Liu) While seemingly unimpressive, over the long run, if these ESG funds yield similar results and beat the market between 24% - 43% of the time, this sector will provide more sustainable, pun intended, results as compared to the 4% of actively managed mutual funds that beat the market over a sustained period. Put another way, ESG fund outcomes could perform five times worse than they have already in 2022 and still have better results than other actively managed mutual funds.
Sharing these data points, I must comment that time is a critical factor when it comes to evaluating the performance of different investment vehicles. ESG funds are still in their infancy when compared to benchmark indices or much older mutual funds. Only over time will we be able to effectively evaluate whether ESG funds outperform other mutual funds. However, with a high-level probability, actively managed ESG funds will not beat the market with any sustained level of success.
Works Cited
Group, Antea. “ESG vs. CSR: Key Distinctions & What Businesses Need to Know.” United States, 2022, us.anteagroup.com/news-events/blog/esg-csr-definitions-differences-sustainability. Accessed 5 May 2022.
Innovations, ADEC. “What Is ESG Investing? - ADEC ESG.” Www.adecesg.com, 2022, www.adecesg.com/resources/faq/what-is-esg-investing. Accessed 5 May 2022.
Liu, Evie. “Sustainable Funds Are off to a Rough Start to the Year.” Www.barrons.com, 14 Feb. 2022, www.barrons.com/articles/esg-sustainable-funds-performance-51644844397. Accessed 6 May 2022.
Perry, Mark. “More Evidence That It’s Really Hard to “Beat the Market” over Time, 95% of Finance Professionals Can’t Do It.” American Enterprise Institute - AEI, 18 Oct. 2018, www.aei.org/carpe-diem/more-evidence-that-its-really-hard-to-beat-the-market-over-time-95-of-finance-professionals-cant-do-it/.
Pippa Stevens. “Your Complete Guide to Investing with a Conscience, a $30 Trillion Market Just Getting Started.” CNBC, CNBC, 14 Dec. 2019, www.cnbc.com/2019/12/14/your-complete-guide-to-socially-responsible-investing.html. Accessed 4 May 2022.
Quinson, Tim. “Many Big ESG Funds Are Just Glorified Market Trackers.” Bloomberg.com, 2 Feb. 2022, www.bloomberg.com/news/newsletters/2022-02-02/many-big-esg-funds-are-just-glorified-market-trackers. Accessed 7 May 2022.
Robbins, Tony. Money: Master the Game. SIMON & SCHUSTER LTD, 2017.
Rosenberg, Eric. “Most Investment Pros Can’t Beat the Stock Market, so Why Do Everyday Investors Think They Can Win?” Business Insider, 31 July 2020, www.businessinsider.com/personal-finance/investment-pros-cant-beat-the-stock-market-2020-7. Accessed 7 May 2022.
Schwartzkopff, Frances. “New Benchmarks Put an End to “Anything Goes” for ESG Indexes.” Bloomberg.com, 27 July 2021, www.bloomberg.com/news/articles/2021-07-27/new-benchmarks-put-an-end-to-anything-goes-for-esg-indexes. Accessed 28 Apr. 2022.
Wheelan, Charles. Naked Statistics : Stripping the Dread from the Data. New York, W.W. Norton & Company Ltd, 2014.
Submitted 5/7/22