ESG Honestly

Posted 30 April 2024

Is it all about returns?

ESG investing has been criticised for detracting from portfolio performance. But for some clients, performance isn’t the only thing that matters. Who are investment managers to tell them otherwise? 

ESG investment funds have had a rough time in the last couple years. This is partly a performance issue: energy stocks have been some of the best performers since Russia’s invasion of Ukraine, and ESG funds tend to exclude them. But the invasion of Ukraine also led to a re-evaluation of priorities for companies and policymakers. This has sprawled into a massive political backlash in the US, where Republican lawmakers have rejected ESG in an apparent ‘war on woke capitalism’.  

The controversy is having a considerable impact on capital flows. The Texas Permanent School Fund has said it will pull the $8.5 billion it has invested with BlackRock because of the investment manager’s use of ESG factors. BlackRock itself has been scaling back its endorsement of ESG, approving significantly fewer shareholder proposals and reducing its involvement with the Climate Action 100+ group. BlackRock is one of many high-profile investors to pull back from CA100+, an activist investment coalition which pushes companies to reduce their emissions. 

Fiduciary responsibility? 

Some of the more vitriolic criticisms of ESG are unique to the American right wing. But even though the debate is much cooler this side of the Atlantic, many people share the underlying scepticism. An Economist article from a couple of years ago, for example, bemoans “The fundamental contradiction of ESG“. 

This fundamental contradiction is usually put along the lines of: investment managers should optimise the performance of clients’ portfolios, and focusing on non-performance related metrics like ESG can detract from this performance, so investment managers shouldn’t pursue ESG goals.  

This line of thinking is best summed up in Bob Rubin’s (not that Bob Rubin) op-ed

“As an investor, your primary concern is the performance of your portfolio. […] Financial institutions serve a critical role in managing clients’ portfolios-that should remain the central focus. It is of paramount importance that financial organizations stick to their core mission rather than diversify into complex societal debates.” 

Vegetarian options 

There are a few things wrong with the argument above. Consider, for example, an analogous argument: chefs should optimise the taste experience for patrons, and focusing on non-taste related factors like health benefits or vegetarian options can detract from that taste experience, so chefs shouldn’t make healthy or vegetarian food. 

Hopefully, that strikes you as a silly thing to say. Lots of people want healthy or vegetarian food, so why shouldn’t chefs be allowed to cater to them?  

How much ESG factors detract from performance – much like the tastiness of vegetarian food – is controversial. If you exclude certain stocks from your portfolio for whatever reason – like oil companies – you obviously will not get the returns that those stocks provide. This puts a theoretical limit on ESG returns relative to unconstrained returns because any fund manager can pick an ESG stock if they think it will do well, but ESG fund managers can’t pick any stock they like. 

In reality, though, the relative performance of ESG and non-ESG portfolios depends on the specifics of capital markets during that time period, and the investment processes of individual fund managers. It could be, for example, that ESG fund managers are more likely to appreciate certain climate or reputation-related risks than non-ESG investors, which in the right circumstances could lead to outperformance.  

This leads on to a more crucial point: even if you thought that ESG factors were likely to detract from performance over a relevant investment horizon, the amount it detracts might be low enough that you think it’s worth it. For some clients, aligning their investments with things their care about is worth sacrificing some potential returns. Who are we to tell those people they should only care about returns? 

Clarity and honesty  

Whether it is worth it can only be decided by investors themselves. But making that decision can be difficult if all you have to go on is vague catchphrases like “environmental, social and governance”. That is why any investment professional selling ESG products needs to be clear about what those criteria amount to.  

Unfortunately, this isn’t always the case. Even for some of the most high profile ESG indices or funds, the selection criteria can sometimes be hard to get straightforward information on, and their ESG scores can produce some shocking results (counterintuitive and opaque selection is what leads to “greenwashing” scandals, after all). The main draw of ESG investing is that it allows investors to vote with their wallets – so investment professionals have to be clear about what they’re voting for. 

Thankfully, new regulations are aimed at improving those standards. They aren’t perfect, but anything that improves clarity and honesty for ESG investing is a plus. The job of investment managers is to manage clients’ investments in the way the clients are most comfortable with. Sometimes, that isn’t all about returns.  

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