By Kelvin Lee, Alonso Munoz
Preface – In a recent pitch to an endowment, our team was grilled about ESG screening criteria, and how we would apply this to the endowment’s “ESG” driven portfolio. As a rational and prudent capital allocator, I conveyed to the endowment committee that we needed to carefully draft policy guidelines that aligned with “their” beliefs, mainly because ESG screens were subjective, and not uniform across the industry. I also made a point that the financial industry was experiencing an ESG “shakeout”, and many of its parameters were relatively new. One of the members, seemingly “boiling” at my comments, asserted that “they” had been investing as ESG investors for 25 years… It took everything in me not to laugh. Why? Their current holdings include oil companies, mining, chemical, airlines, international companies with questionable governance, and much more. I spared our team the drama and left that dig out of the meeting.
Thereafter, Kelvin and I thought it prudent to provide some facts and thoughts about ESG, enjoy. – Alonso Munoz
If you take anything away from this post, please look at the title. Environmental, social and governance, or ESG, investing hit its marketing acme in 2021, and since then, ESG investments by volume in mutual and exchange traded funds have declined by more than 70%. Folks have lost interest in ESG themed investing likely due to the lack of performance, cluttered clarity, and high fees.
We know what ESG stands for and generally what ESG involves. It’s something along the lines of clean energy, general corporate diversity, and community benefits. But these are subjective interpretations, and the issue comes with quantitatively measuring ESG. How are you going to invest in something without being able to define it? Across rating agencies, the definition and ESG criteria aren’t standardized. MSCI looks at 37 ESG metrics, Bloomberg looks at 120 and Sustainalytics examines 155 different points of criteria. As a result, ESG scores differ. Take Nissan for example. Sustainalytics gives it a score of 31.87, S&P Global gives the company a 77 and MSCI gives it a BBB ESG rating.
ESG metrics are meaningless if they’re subjective and inconsistent. Regardless of industry, standard financials like cash flow, revenue and profitability are dependable metrics for comparison. An ESG standard such as “employee safety” isn’t. The Onion (the publisher) would arguably then have a better governance score when compared to Patagonia (creator of the finance vest) since their journalists are hurt less than Patagonia’s warehouse employees. ESG scores are much more correlated with the quantity of voluntary ESG-related disclosures rather than a firms’ compliance records or actual levels of carbon emissions. In current times, anything can be ESG. Even Raytheon, the manufacturer for Javelin Missiles, has an ESG MSCI A rating! Who knew that defense manufactures making personnel killing explosives were great for “social investing”.
Prejudices and emotional subjectivity ultimately plague ESG ratings since measurable economic metrics can be mostly ignored. That’s when a company like Tesla, arguably the most forward-thinking electric vehicle & clean energy company, gets kicked out of the SP500’s “ESG index” likely due to its CEO’s tweets. How can anyone with basic common sense argue that Tesla isn’t “ESG”.
Blackrock’s Larry Fink (unsurprisingly) pioneered a lot of the ESG ETFs out there. His famous annual letters highlighted the importance of sustainable investing and the focus of ESG investing. Companies that score higher on ESG are likely to be less risky and better positioned for the long term since they are focused on sustainability…
“The more your company can show its purpose in delivering value to its customers, its employees, and its communities, the better able you will be to compete and deliver long-term, durable profits for shareholders.” – Larry Fink
Maybe that makes sense to an investor who wants to “sleep well at night”, but that doesn’t explain why Blackrock’s ESG awareness fund (currently the largest ESG fund out there), or most ESG funds for that matter, lag the S&P500. It’s a material issue that many have correctly pointed out in doubting ESG strategies. Didn’t Larry Fink say, “long term, durable profits for shareholders”? That’s no different from investing in general, aside from the juicy fees ESG funds generate for their managers.
Here’s what BlackRock’s former Chief of Sustainable Investing had to say:
“There’s no reason to believe [ESG investing] achieves anything beyond sort of giving [asset managers] more fees.” – Tariq Fancy
We look for opportunities every day as part of our discipline, and “ESG” fundamentals like carbon offset credits and renewable product offerings are all under purview of basic investment research. ESG is just another buzzword, and one that is costing investors more money. ESG ETF’s and mutual funds universally have higher expense ratios, and many underperform the markets. In typical fashion, Wall Street laughs all the way to the bank as they can package the “idea” of ESG and sell it to anyone with an investment account. Most ESG funds don’t even hold anything remarkably different than your standard index. Take a peek for yourself, you’ll see the usual cast: Apple, Microsoft, and other mega caps as the largest holdings.
Just to be clear, we aren’t opposed to having a positive impact on the environment, honest and clear corporate management, social initiatives that lead to a more equitable world. We unequivocally support these concepts, not to mention our firm is minority led, alongside a truly diverse team. These are great things, and investors should invest in companies that have relatable values and goals. However, don’t get muddied by the ESG clown show. If you want climate friendly companies, then invest in places that make sense. ESG metrics such as amount spent on conservation funding would lead you to invest in Exxon or Chevron since they donate the most, even though they’re the largest perpetrators of fracking. ESG is non-logical, and we would much prefer to look at quantifiable information for investment decisions. Companies know this and they take advantage of ESG investors. Looking at earnings calls over the past decade, we see that firms falling short of earnings expectations are more likely to focus on subjective-based performance criteria when falling short on objective financials. It’s not an encouraging sign that increased ESG language is more evident among firms missing earnings estimates than ones that beat.
So far, the ESG designation has been beset by greenwashing and lackluster results against the backdrop of higher management fees. It’s no wonder why investors and portfolio managers are shying away from ESG funds. However, the trend over the last year to standardize ESG metrics with full transparency is a step toward the right direction, and we won’t dismiss the future possibilities of ESG analysis. But until then, we agree with London Business School’s Alex Edman:
“ESG is both extremely important and nothing special. It’s extremely important because it’s critical to long-term value, and so any practitioner or academic should take it seriously, not just those with “ESG” in their job title or list of research interests. Thus, ESG doesn’t need a specialized term, as that implies it’s niche. Considering long-term factors when valuing a company isn’t ESG investing; it’s investing.”
To contact the author of this story:
Kelvin Lee at email@example.com
To contact the editor responsible for this story:
Alonso Munoz at firstname.lastname@example.org