FILE - Wind turbines stand at a wind park in Marsberg, Germany, June 15, 2022.
California Gov. Gavin Newsom this week released a lengthy commentary defending so-called ESG investing, which he wrote has “proven results.” His defense requires fact checking and context.
Environmental, Social and Governance (ESG) is the latest investing trend that claims investors can earn higher returns while also “doing good” on important social issues such as a company’s impact on the environment or how it treats its workers.
According to Newsom, ESG investing “prioritizes sustainability, invests in technologies of the future, and factors in the risks associated with climate change–wildfires, floods, hurricanes, and droughts.” These claims are simply untrue.
Despite the rhetoric, ESG investments are often indistinguishable from broad-based investments. Investor’s Business Daily’s top ESG firms, for instance, include Microsoft
From an investment manager’s perspective, there are distinct advantages from labeling funds as ESG-compliant rather than ESG-noncompliant: ESG funds can “charge fees 40% higher than traditional funds making them a timely answer to asset management margin compression.”
Given their ability to charge investors 40% more to provide investors with the same service, it should not be surprising that money managers such as Larry Fink from Blackrock embrace ESG investing. Nor should it be surprising that money managers want to steer large sums into ESG-labelled funds.
Worse than not understanding why some money managers would prefer ESG investments, Newsom perpetuates misinformation regarding the value of the investment strategy to investors. For instance, his article justifies the fad by comparing returns of ESG funds to the performance of fossil fuel stocks.
The sectors that outperform the market average will typically vary in the short-term. While it is completely true that ESG funds, which are overweighted in information technology stocks, outperformed energy stocks in the previous bull market, it is equally true that the investors who called the recent low for Exxon Mobil’s stock have outperformed typical ESG stocks.
Since October 2020, investors could have earned a more than 240 percent return investing in Exxon Mobil (excluding dividends) compared to a 4 percent return for investors in the QQQ
Analyses that provide a more robust examination of the investment potential consistently demonstrate there is no return premium from ESG investments. As summarized in a piece in the Harvard Business Review,
ESG funds certainly perform poorly in financial terms. In a recent Journal of Finance paper, University of Chicago researchers analyzed the Morningstar sustainability ratings of more than 20,000 mutual funds representing over $8 trillion of investor savings. Although the highest rated funds in terms of sustainability certainly attracted more capital than the lowest rated funds, none of the high sustainability funds outperformed any of the lowest rated funds.
A 2022 paper in the Journal of Impact and ESG Investing similarly found no “statistically significant difference between ESG and non-ESG funds”. My 2019 analysis showed that, once the higher fees associated with ESG are considered, the returns of these portfolios are even worse.
Ultimately, Newsom confuses the ability of ESG funds to “attract” capital with the returns the funds provide. Investment fads are not the same thing as generating better long-term returns.
In response to the evidence presented above, Newsom could respond that higher returns are not the only ESG goal. There is also the goal of doing good. Here again the evidence demonstrates that ESG’s performance does not match its rhetoric.
Let’s start with CalPERS and CalSTRS, the State of California’s main public employee pension funds. These funds, supposed leaders in the ESG community, held $900 million of investments in Russia as of February 2022. While not investing in belligerent nations that invade their neighbors, torture civilians, and directly create food shortages that threaten billions of people with food insecurity is not typically cited as an ESG criteria, it should be.
The purpose of noting that CalPERS and CalSTRS were invested in Russia is not to pick on these funds but to highlight the problem of correctly identifying what is an ESG investment and what is not an ESG investment. It is much harder to achieve than Newsom realizes.
As a recent Wall Street Journal report discovered, whether a company receives a high ESG rating or not varies significantly depending on which “provider” is rating the companies. Like beauty, ESG is very much in the eye of the beholder.
The situation is even worse than this, however. According to the Harvard Business Review analysis
researchers at Columbia University and London School of Economics compared the ESG record of U.S. companies in 147 ESG fund portfolios and that of U.S. companies in 2,428 non-ESG portfolios. They found that the companies in the ESG portfolios had worse compliance record(s) for both labor and environmental rules. They also found that companies added to ESG portfolios did not subsequently improve compliance with labor or environmental regulations.
In other words, companies often labeled as ESG do a worse job of adhering to the subjective ESG standards than those listed as non-ESG compliant. A perfect, yet timely, example of this phenomenon is the failed crypto-market FTX, which until its spectacular bankruptcy was highly rated on ESG management criteria.
Large public pension funds like CalPERS and CalSTRS have a fiduciary responsibility to their pensioners and taxpayers. The intrinsic problems of ESG investing violates these fiduciary responsibilities and nothing written by Governor Newsom changes this reality. ESG not only fails to achieve its lofty goals, but it also makes these goals harder to achieve.
