From the desk of Steve Strazza @Sstrazza
What’s the FIRST question investors should ask themselves and have a clear and concrete answer to before putting money in the market?
It is literally step one. The cornerstone of any strategy or trading plan…
What is my objective?
Every investor should examine this thoughtfully and keep it top of mind to ensure that their investment decisions are aligned with their investment goals.
Usually, the answer is pretty simple and comes down to maximizing returns, or more importantly minimizing losses, in a way that fits within each individual’s unique preferences.
But as we’ll explore in this post, this isn’t always the case, and sometimes it can be a bit nuanced – as is the case with Environmental, Social, and Governance investment strategies.
So as an exercise let’s put ourselves in the shoes of ESG investors and ask a few simple questions…
1. What is “ESG Investing?”
Most of us know that ESG investing is supposed to be about allocating capital to those companies that are good stewards in terms of their environmental, social, and governance practices in a way that they are meant to have a positive impact on climate change and other social issues.
But, what is it really?
Unfortunately, due to issues like “greenwashing“ and the same misleading financial marketing practices that have plagued the industry for decades, ESG investing has morphed into something it was never intended to be.
Making matters worse, most average investors have no idea this is the case, and are being completely duped by the delusory messaging surrounding many of these vehicles.
This has quickly become one of the major scams Wall Street has come up with in recent years. But don’t take it from us, here’s an expert’s opinion…
Tariq Fancy is the former Chief Investment Officer of Sustainable Investing at BlackRock, a firm that’s been at the forefront of popularizing ESG Investing in recent years. Here’s what he recently had to say:
In truth, sustainable investing boils down to little more than marketing hype, PR spin, and disingenuous promises from the investment community.
Based on what we’re seeing in price, we definitely agree with Tariq. We’ll get into this more below, but for those interested in learning more about this, we highly encourage you to read his entire op-ed, here, and/or watch the interview he gave about it on CNBC this week, here.
There aren’t too many people out there more qualified to speak on this topic as he is. Now for the next question…
2. How are companies judged on these metrics?
Now let’s take a look at how ESG scores are determined, as well as the factors that are considered by the rating agencies and financial data companies that design and publish these rankings…
And just as importantly, we’ll talk about some of those factors that are NOT considered. This is where things start to get a little funky, so pay attention!
Taking a step back, the main issue here is really the mere existence of such well-defined ranking systems. Allow me to explain:
Since companies know what metrics they are being judged on, they can effectively “window dress” or take advantage of that information in order to achieve a higher score and thus join in on the party and inflows that come along with being dubbed an “ESG-friendly” stock. For example, companies that attain high scores will be included in the multitude of passive vehicles that now have an ESG requirement (in some form or another) as part of their investment mandate.
This has created a common practice whereby companies consciously make decisions in order to drive their scores up, regardless of whether these decisions are good for the environment and society at large… and maybe worse, regardless of how these decisions will impact their bottom line!
For investors like us, this irresponsible behavior is merely another arbitrage opportunity and market inefficiency that we can exploit and profit from.
Tariq would agree with this, as he also makes mention of the rising popularity of this exact practice:
There are even portfolio managers who actively mine ESG data to bet against environmentally responsible companies in the name of profit, a short-selling strategy.
We downloaded the ESG rankings and scores for all S&P 500 components as published by the market data company Refinitiv. They assign separate environmental, social, and governance scores, in addition to a composite ranking based on all three, which is referred to as the “Total ESG Score.”
The table below is a list of about the 30 highest-rated stocks, ranked by their total score, and also includes their “Environmental Score.”
When I looked at this list I was absolutely shocked to see some of the names that ranked toward the top.
Let’s take Carnival for example, and look at the breakdown of this company’s rankings to see how this serial polluter* managed to achieve such a high total score.
It’s simple really and comes down to two things, one of which we already mentioned, being “window dressing.” This is more commonly referred to as “greenwashing” in the ESG space.
This simply means that companies like Carnival will make a concerted effort to score high on the social and governance metrics in order to compensate for their low environmental score.
And how is it that Carnival gets a 90 score for their “product responsibility” considering their well-documented history of polluting waters?
This is a whole other rabbit hole to go down, but I want to touch on it briefly as this is also the reason why there are some very surprising companies on this list outside of Carnival…
For example, how do the world’s two largest Tobacco manufacturers, commonly referred to as “vice stocks,” Altria and Phillip Morris both rank in the top 10? These companies literally sell poison, yet according to their ESG scores, they are model corporate citizens!
Or, how about the United States’ largest landfill operator, Waste Management coming in at #2 overall! Anyone else shocked by this?
How about all the companies on the list that operate either directly or indirectly in the fossil fuel business such as Halliburton, General Motors, and Ford?
Here’s how… a company’s ESG score has absolutely NOTHING to do with the product they sell or line of business they operate in. So what would seem to be the most important variable of all – what a company actually does – has zero impact on its score.
Along with the now very popular practice of “greenwashing,” these are the two main reasons why so many of the companies you would expect to be ranked at the bottom of the list, are instead ranked toward the top.
This would also explain how a company like General Motors scores an 88 on “emissions” and even gets a 100 on “product responsibility” – you can’t make this stuff up!
* I was actually just ranting about this on Twitter as this issue hits near and dear to my home. We recently passed a local referendum banning Carnival ships from docking here in Key West due to the damage they cause to the Great American Reef, not to mention all the fines we’ve had to levy on them for dumping right off our shores over the years. Well, it appears they’ve successfully lobbied Florida’s state government once again and are well on their way to having that referendum overturned. Never underestimate the power of Corporate Lobbying. Read more about it here.
Let’s move on to the really interesting part now…
3. What is the strategy’s objective?
So, what is this whole movement really about…?
Are ESG investors trying to make money, or are they trying to save the world?
Let’s be real here… While the two objectives aren’t necessarily mutually exclusive, they’re both difficult enough to achieve in their own right that doing both simultaneously poses quite the challenge. I think it’s fair to say, you really can’t do both… at least not consistently.
Although, it seems some of these fund managers tend to think otherwise…
Let’s look at the investment objective of the largest ESG ETF by AUM, the iShares ESG Aware MSCI USA ETF $ESGU. Ironically (or maybe not so much), it is managed by BlackRock which is the parent company of iShares, as well as Tariq’s former employer.
This is straight from their website:
The iShares ESG Aware MSCI USA ETF seeks to track the investment results of an index composed of U.S. companies that have positive environmental, social and governance characteristics as identified by the index provider while exhibiting risk and return characteristics similar to those of the parent index.
I think the key phrase and takeaway from this is that whether these stocks actually have positive ESG characteristics is decided or “identified by the index provider.” In other words, while they might “seek to track” the results of ESG-friendly companies, at the end of the day anything goes and they have the final say about what stocks are worthy enough to be included in the fund.
If you take a deeper look at the website, you’ll also notice it’s littered with disclaimers. Far more than the usual ones, too. Take this one for example, which explains how these ESG ratings are used in terms of the fund’s asset allocation strategy:
The metrics are based on MSCI ESG Fund Ratings and, unless otherwise stated in fund documentation and included within a fund’s investment objective, do not change a fund’s investment objective or constrain the fund’s investable universe, and there is no indication that an ESG or Impact focused investment strategy or exclusionary screens will be adopted by a fund.
So again, despite being branded as an “ESG fund” the managers more or less reserve the right to invest however they want.
Therefore, the answer to the question “what is the strategy’s objective” is unfortunately quite different from the answer we’d likely get if we phrased it slightly differently and asked…
“What is the objective of an ESG investor?”
They would likely be more concerned with the actual social and environmental impact that their dollars are having which would make sense as that’s really the only thing that differentiates these funds from their alternatives.
In fact, something we’ve discussed internally and on Clubhouse quite a bit of late is that many ESG investors are simply allocating capital in this way as a function of “virtue signaling” as it seems to be an ideal option for aligning one’s investments with their value system. Whether or not the intended results are actually achieved is a whole other story though.
Randy Bullard wrote an excellent blog post on this exact topic this week. You can read that here and learn more about “Green Virtue Signaling” as well as the potential risks it poses for investors. But here is the long and short of it in his words:
The greater risk is “green virtue signaling” — choosing ESG investing as a means of publicly professing ESG values, without actually achieving any beneficial ESG outcomes…The only real sustainable value proposition for ESG investments is… as a means to align a portfolio with the individual investor’s values.
The ETF providers and fund managers, on the other hand, likely care more about returns and a lot less about the actual impact these vehicles are having on the world. That’s the only “value proposition” they care about. These funds are easy to package up in an appealing way and pitch as impact investing strategies, making this trend an absolute home run for investment managers.
Whether they actually benefit their clients’ portfolios… or the world for that matter – it’s hard to say, but there’s really no strong evidence suggesting this is the case.
This brings us to our next question…
4. Are ESG funds actually achieving either of their objectives?
Let’s start with the “impact” side of things…
First of all, to be fair, most funds like ESGU do have additional filters that they overlay on top of the ESG scores in order to remove “vice companies” like the Tobacco manufacturers discussed above.
They also filter out stocks that operate in businesses that are believed to be unhealthy for the environment. Any stocks that meet the following criteria are excluded from ESGU:
- Associated with controversial, civilian and nuclear weapons and tobacco
- Derive revenues from thermal coal and oil sands extraction
So, at least this is good news for investors who want their dollars to have a social impact (even though there is no evidence this is the case), but how about those investors who are expecting outperformance by means of investing in these top-notch corporate citizens?
We dug into this a bit to see if there is any evidence at all to support the claim, or should I say the wishful hypothesis, that stocks with high ESG scores perform better than those with lower scores, all else equal.
To do this, we built a custom ratio that compares the top 20 ranked stocks by total ESG score to the bottom 20. Here’s what that looks like… Not so pretty, is it?
Over the past half-decade, your portfolio would have been a whole lot better off it was invested in stocks with the lowest ESG scores as opposed to those with the highest.
Maybe inverse impact investing funds will be the next trendy factor or strategy! I’m kidding. Don’t count on it. But at least you now know the truth about ESG stocks.
Now, what if we did this same exercise but just focused on those stocks with the highest and lowest environmental scores? Considering how the clean energy space has been on a tear in recent years, stocks with high scores in this area must be outperforming… right?
Nope. It’s actually quite the opposite. Just like the ratio based on the total scores above, the stocks with the lowest environmental ratings have been consistently outperforming those with the highest scores for over 5 years now. In fact, the underperformance by the top environmental stocks is even more severe than the stocks with the highest total score.
What the heck is going on here?
Let’s visualize just how bad the discrepancy in returns has been by looking at the 5-year performance of these two custom indexes.
In theory, if you had bought the 20 “dirtiest” stocks measured by their environmental score as opposed to buying the 20 “cleanest” ones, you would’ve increased your returns by nearly 5x over the past five years! Wow is all I have to say about that. Just WOW.
But I know what you’re thinking – “these are only custom indexes.” They served their purpose in terms of myth-busting the idea that there is any sort of positive correlation whatsoever between a stock’s performance and its ESG Score. In fact, if anything there might be a pretty strong negative correlation there.
But how about the actual publicly traded vehicle that most investors are using to express a bullish view on ESG stocks. Let’s compare the returns of ESGU to some of the most popular index ETFs to see if the strategy has generated any positive alpha since its inception.
Since the ETF launched back in December of 2016 it has marginally outpaced the S&P 500 by about 10% (or a bit under 2% per annum). Although, if you were invested in the leaders like we always like to be, you would’ve earned about double the return of ESGU by owning the Nasdaq 100 instead.
So, what did we learn about ESG today? Well, in terms of answering our initial questions, there was a lot of myth-busting.
Based on our research, ESG funds are just a more attractive way to market the same old index funds that most passive investors already have exposure to.
In terms of how virtuous these investments are, while they do make an effort to overweight ESG-friendly stocks relative to other funds, they fail to do so in any meaningful way.
One of the drivers of this problem is that the MSCI and Refinitv rating systems are a crock in my not so humble opinion. They actually incentivize companies that are notorious ESG offenders to overcompensate for this and intentionally inflate their overall scores. This can easily be done by taking advantage of other scoring metrics, particularly those around governance and social issues.
Sadly, there is absolutely no evidence to suggest investing in ESG funds has been or will be a catalyst for good. Again, due to incentives of company executives – in this case, their short-term focus on shareholder returns above all else – it’s unlikely that capital inflows and the resulting higher prices of these companies are going to change their behavior in any way significant enough to have a positive social or environmental impact.
And last but not least, there is also zero evidence to suggest that companies with higher ESG scores or ESG investment vehicles provide any alpha whatsoever over their alternatives. In fact, we found quite the opposite to be true.
Long story short, any disciplined investor’s behavior should emanate directly from their objectives. And if those objectives have anything to do with generating alpha, or maximizing returns, then ESG Investing is likely not for you.
I encourage you to take some time to rethink what your individual objectives are as a market participant.
Are you here to make money…? Or, are you here to save the world…?
We think it’s pretty difficult to do both in the market, so our advice would be to focus on just one of the two.
As for us, we’re in the market for one reason and one reason only, and that is to make money. Everything else is secondary.
After all, we can always donate our gains to charity later on 😉
We want to know what you think about all this so shoot us a note with some feedback and feel free to tell us about your objectives as an investor. We love hearing from our readers!If you enjoyed this post and want access to our premium research, start your 30-day risk-free trial or sign up for our “Free Chart of the Week” to receive more free research like this.