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Should ESG investing be criminalized?

The question, regrettably, is not a joke.


Earlier this month, three members of US state New Hampshire’s House of Representatives introduced a bill that opposes ESG investing. It reads, in part:

Executive branch agencies that are permitted to invest funds shall review their investments and pursue any necessary steps to ensure that no funds or state-controlled investments are invested with firms that invest New Hampshire funds in accounts with any regard whatsoever based on environmental, social, and governance criteria.
New Hampshire House Bill 1267

Hmm. Taken literally—how else should legislation be taken?—that provision forbids New Hampshire officials from investing the state’s moneys with portfolio managers who pay “any regard whatsoever” to “governance criteria.” If investment professionals are bothered that a company appointed the CEO’s relatives to its board of directors, or flunked a cybersecurity audit, they cannot act on those matters without endangering the New Hampshire official who selected them.

(It’s worse than that. The bill states that those who invest on behalf of the state of New Hampshire may not pay governance issues “any regard.” Per the proposal’s wording, portfolio managers may not even think about such topics.)

Further problems

The environmental and social provisions aren’t much better. Presumably, the bill’s authors seek to prevent stocks from being selected because their organizations are deemed by the portfolio managers to be “good corporate citizens.” But again, the bill’s language is overly broad. Thus, whether a company might pay steep fines for pollution or face an impending labor strike would be off-limits.

f there were any remaining doubts about this proposal’s sanity, the severity of its penalty should erase them. The bill reads: “It shall be a felony punishable by not less than one year, and not more than 20 years imprisonment.” Well, now. The maximum permissible sentence in New Hampshire for kidnapping, first-degree assault, or sex trafficking is 15 years. Apparently, none of those crimes are as depraved as permitting a portfolio manager to invest through ESG principles.

The Underlying issue

Its drawbacks aside, the bill raises a legitimate point: What is the outlook for ESG investing? Those who sponsored the legislation imply that the ESG mindset is doubly harmful, in that it lowers a portfolio’s return while increasing its risk. The state’s officials, they assert, possess a fiduciary duty to “maximize financial returns and minimize risk.” But state representatives are generalists, not subject-matter experts, and their viewpoints in this instance are decidedly partisan.

Let’s consider instead what impartial researchers believe. By and large, they ignore the prevailing discussions. The common debate about ESG investing consists of proponents arguing that considering ESG factors avoids future woes, while detractors argue that addressing such concerns harms profitability. ESG is “all about woke diversity,” said Home Depot HD co-founder Bernie Marcus. “Things that don’t hit the bottom line.”

This is an old controversy recast. Long before ESG existed, business school professors debated whether American businesses paid too much attention to current profitability, too little, or just the right amount. Running a corporation inevitably involves trade-offs: How much to spend today to avoid tomorrow’s problems? For that question, the accepted answer is, “It depends.” The dispute cannot be resolved by theory.

Potential objection 1: Lower risk = Lower returns

There are, however, more substantial critiques of ESG investing. One involves taking the claims of ESG proponents at face value. If evaluating ESG issues is merely another form of risk control, then funds that invest with ESG principles in mind will, on average, own less-risky stocks. But, comes the reply, since risk and return are related, with higher risks generating higher expected returns, ESG funds will make less money than their competitors.

Fair enough. This argument, however, undercuts the New Hampshire proposal. There is nothing incorrect about investing in securities that have lower expected returns because they carry lower risk. If there were, only portfolio managers who invested in extremely speculative securities would be permissible. For example, it would be illegal to invest in blue-chip U.S. equities, because emerging-markets stocks have greater risks and therefore superior expected returns.

It should also be noted that the link between such theory and practice is extremely tenuous. Although the precept is credible if all things were equal, all things are rarely equal. Thus, its explanatory power is weak. For example, blue-chip U.S. equities have whipped emerging-markets stocks in recent decades.

Potential objection 2: Higher popularity = Lower returns

Another objection to investing on ESG principles is that because so many investors are attracted to companies with high ESG scores, the prices for such securities are inflated. Thanks to their popularity, their past performances have been strong, but their future returns will be weaker. Pay more, get less.

This argument, too, is rational. It would certainly apply if the facts supported it. That, however, is far from clear. For example, when Morningstar conducted an in-depth study of global equities, covering the 11 years from 2009 through 2019, it found that stocks with the best ESG scores were cheaper than their competitors. On average, they had both higher dividends and lower price/earnings ratios.

In addition, while logically sound, the Popularity Asset Pricing Model is difficult to implement. After all, before stocks lag because they have become too costly, they outperform while becoming overpriced. Is ESG in the first stage or the second? The question is unanswerable. What’s more, if the answer is that ESG stocks still occupy the first stage, then their expected returns are relatively high, not low.

Potential objection 3: Actual performance

Because so many parties (including a Morningstar subsidiary) publish ESG risk scores, and because investments’ performance can be measured over many periods, for many countries, people can reach whatever conclusion they wish. And since ESG investing is both a highly politicized topic and one that can potentially generate substantial profits for its proponents, that is in fact what has occurred. Either side has issued reports that appear to validate their beliefs.

I will therefore set those studies aside. No doubt many are estimable, but as they yield conflicting results, I conducted my own investigation instead. I sifted among all large-blend U.S. equity funds with five-year track records (longer would have been preferable, but few ESG funds existed a decade ago), sorting them into four camps: 1) index non-ESG funds, 2) index ESG funds, 3) active non-ESG funds, and 4) active ESG funds.

I hoped to present four results, but I could not fairly do so. The index non-ESG funds contained several “low-volatility” funds that tinkered with the conventional strategy, thereby reducing that group’s return. Instead, I opted to show the industry’s two largest index funds,

Vanguard Total Stock Market ETF VTI and Vanguard S&P 500 VOO. Since Vanguard also offers an indexed ESG investment, Vanguard ESG U.S. Stock ETF ESGV, I included that, too.
(I omitted risk measures, because Potential Objection 1 notwithstanding, the standard deviations of returns for all groups were similar.)

ESG return

The outcome is an investment Rorschach test. If you see victory for either ESG funds or their rivals, that is what you wish to see. One side won the indexing battle, the other side won the active battle, and in neither case were the results significant. No conclusions can be drawn from such modest differences.

Now, if you wanted to revise New Hampshire’s bill to imprison officials who hire active portfolio managers …



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