By Kyle Balkissoon
Recently, we read an opinion piece in the Wall Street Journal that had some unfounded criticisms of sustainable investing. As practitioners in the space, we thought we would address them below.
Original article: https://www.wsj.com/articles/sustainable-investing-is-a-self-defeating-strategy-11600466998?st=jyu2wc8g4ukgjiq&reflink=article_email_share
Argument: If, say, oil stocks sell at low prices relative to earnings and prospects, those who buy them stand to gain.
Rebuttal: This is a meaningless statement because it implies that if active managers just bought everything cheap they should outperform, but sadly that’s not how the markets work.
Argument: The problem is that the scores from different providers disagree dramatically.
Rebuttal: Scores can vary based on provider differences in rating criteria and whether those criteria reflect current state or improvements. Scores can also be made on absolute terms or against peer groups which can be defined in different ways. The disagreement in scores reflects differing methodologies for scoring companies, which is not a problem as it gives investors multiple choices.
Argument: ESG ratings tend to be divorced from considerations of how environmental, social and governance performance can influence future financial results.
Rebuttal: Again, there are few clear relationships between “fundamental” metrics and consistent outperformance. Value may outperform over the long term, however mapping value screens to short term outperformance does not work well. Holding ESG to a higher bar than traditional value investing makes little sense as it does not posit to generate excess returns.
Argument: Xcel Energy has one of the biggest carbon footprints in the electric utility industry. Xcel ranks poorly because it generates a substantial share of its power from coal. But Xcel is the first U.S. utility committed to going 100% carbon-free by 2050 and is a leader in building wind-generation facilities. Should we refuse to invest because of its carbon emissions, or do we approve of the company because of responsible investments that may ultimately lead to greater profitability?
Rebuttal: Xcel is a perfect case of trading off where companies currently are and where they are going, as efficient capital markets require different opinions of asset prices and investor preferences. Some ESG investors may thematically invest in companies that are moving in the right direction, while others may allocate capital to those that score well on current performance. This is no different than choosing between growth stocks or dividend stocks.
Argument: Some ESG providers have also claimed that social investing can enhance returns. During particular periods, some funds with specific ESG mandates have outperformed. In the first half of 2020 funds with no oil but high tech stocks did well as the price of oil plummeted and tech stocks soared. But no credible studies show that ESG investing offers consistently higher long-term returns. Such funds are less diversified than broad-based index funds and thus are riskier. They also have higher expense ratios, which tends to lower investment returns.
Rebuttal: As an ESG product provider, we will stand behind our 6.5 years of gross and net outperformance vs the SP500. We will argue that ESG does not enhance nor does it hurt our returns; and that proper portfolio construction, which involves formulating expectations of outperformance combined with smart risk management, something that is not being considered by the author, is the driver of returns.
Argument: ESG investing is inherently at odds with the goal of earning higher returns. Investor taste does influence asset prices. But as a thought experiment, suppose that oil stocks are so abhorred that they now sell at low prices relative to their earnings and prospects. That means they will offer higher future returns, and portfolios excluding them might underperform.
Rebuttal: This again requires a view of the future and an assumption that markets are currently not pricing oil stocks efficiently. If the author feels strongly about this thesis he can invest accordingly. We unfortunately do not possess a crystal ball into the future earnings of oil companies, however we do believe that markets currently price in market expectations as to the value of the stocks in them.
Argument: What should you do if you’re attracted to ESG investing? Putting all your investment portfolio into ESG funds is neither prudent nor virtuous. The core of every investment portfolio should consist of low-cost, broad-based index funds. If you want some of your investments to go into funds with particular mandates such as renewable energy, do this as an add-on to your core portfolio. But don’t be misled by marketing claims. It isn’t easy to do well by doing good, and ESG funds may accomplish neither objective.
Rebuttal: We will agree it is not easy, in general, to do well against the market, however we argue that one could replace low-cost, broad-based index funds, with low-cost broad-based ESG funds and achieve similar returns given proper portfolio management. Active management, combined with exposure to companies that outperform in investor ethical preferences, can add alpha.