As predicted by financial theory, stocks of companies with positive environmental, social, and corporate governance (ESG) records underperformed the market. But the problems for ESG investors don’t stop there.
Recently, Advisor Perspectives published two articles on the problems with ESG investing; both are well worth reading.
The first, by Michael Edesess, noted that the marketing of ESG funds smacks of cynical, and occasionally meaningless, jargon aimed mainly at asset gathering and fee optimization, as opposed to any useful social or societal objective. The second, by Larry Swedroe, like Edesess, noted the wild proliferation of these funds, and also cited academic work that found that ESG funds not only did a poor job of selecting companies with low carbon emissions, but rather seemed to favor those with high lobbying expenditures.
Worst of all, ESG funds underperformed the non-ESG funds run by the same managers.
The underperformance of ESG offerings is, of course, to be expected; in fact, it falls directly out of basic equilibrium finance theory. Assume, for example, that half of investors arbitrarily shun companies whose tickers begin with the letter “A.” The price and valuations of those companies will fall and dramatically raise their expected returns to their remaining investors.
Something of the sort has happened with tobacco and alcohol stocks which, over nearly the past century, have been shunned, for political or religious reasons, by a number of investors, the results of which are clearly visible in the table of industry returns since 1926:
Table 1. Returns of Industry Groups, July 1926 to September 2021
Aircraft
|
12.43%
|
Tobacco
|
12.27%
|
Medical Equipment
|
12.22%
|
Heavy Machinery
|
12.10%
|
Alcohol
|
12.05%
|
Scientific Equipment
|
12.01%
|
Pharmaceutical
|
12.01%
|
Banking
|
11.61%
|
Electrical Equipment
|
11.40%
|
Boxes/Cans/Containers
|
11.21%
|
Retail
|
11.20%
|
Restaurants/Hotels
|
10.98%
|
Automobiles
|
10.88%
|
Entertainment
|
10.84%
|
Electronics
|
10.80%
|
Chemicals
|
10.76%
|
Food
|
10.75%
|
Heavy Machinery
|
10.45%
|
S&P 500
|
10.44%
|
Finance
|
10.20%
|
Oil
|
10.05%
|
Insurance
|
10.04%
|
Business Services
|
9.90%
|
Apparel
|
9.76%
|
Building Materials
|
9.68%
|
Consumer Nondurables
|
9.63%
|
Mining
|
9.56%
|
Telcom
|
9.46%
|
Utilities
|
9.07%
|
Publishing
|
8.84%
|
Transportation
|
8.60%
|
Shipping
|
8.57%
|
Agriculture
|
8.52%
|
Textiles
|
8.50%
|
Construction
|
7.83%
|
Recreational Equipment
|
7.41%
|
Steel
|
7.21%
|
Wholesale
|
7.10%
|
Coal
|
5.90%
|
Real Estate
|
4.90%
|
CPI
|
2.92%
|
Source: Ken French Data Library
Investors who took tobacco and alcohol stocks off the hands of the righteous did well indeed, earning annualised returns that were 183 and 161 basis points higher, respectively, than the market. These two margins, when annualized over nearly a century, are hardly chump change.
No matter how much you or I might abhor companies that pollute the planet, gouge the sick with criminally high pharmaceutical prices, produce dangerous weapons for public purchase, or poison our democracy with dangerous conspiracy theories, we can’t make the shares of those companies disappear; someone will own them, and the more abhorrent those companies are, the higher the return those shareholders will reap.
Nor is that the end of the bad news for ESG investors.
If a shunned company gets cheap enough, it obviously becomes more likely to get taken private, further removing it from public scrutiny. In this regard, the recent ExxonMobil board insurrection led by Engine No. 1 is instructive, demonstrating how even small outside shareholders can curtail further drilling for fossil fuel. Good luck trying that with Koch Industries. Observers of the oil industry have recently noticed, for example, that while publicly traded companies have radically curtailed exploration, the slack has been taken up by private ones.
All of which suggests a better way of how investors can make the world a better place: continue to hold sinful companies in cap-weighted fashion, preferably in a passive fund, and assign the excess returns that accrue to those companies to advocacy, particularly of the sort pioneered by Engine No. 1. One way to do this is through Engine No.1’s VOTE ETF.
One more thing: the sharp-eyed will notice that I put the “G” in the title in parentheses. While I’m dubious about socially and environmentally responsible investing, attention to corporate governance will probably benefit your returns. Starting with the South Sea Bubble of 1719–1720, the history of finance is rife with corporate executives who treated their companies as their private piggy banks, from South Sea’s notorious John Blunt to the rogue gallery of Enron’s leadership, who freely spent their shareholders’ money on corporate jets, mansions, and other luxuries. (Its huge fleet of high-end aircraft was known inside the company as the “Lay family taxi” because of its deployment for shuttling around Chairman Ken Lay’s children to and from social events.) If you put a gun to my head and forced me to pick stocks, my first criteria would eliminate all companies whose executives made extensive personal use of corporate aircraft or who had bought eight-figure real estate, factors which have been shown to knock double digit percents off of stock returns.
I don’t know of a more useful rule of thumb in finance than this: The more investors are aware of a particular company or asset class, the more capital gets thrown at it, and so the lower the long-term returns will be. (This truism never fails to remind me of Peter Lynch’s favorite stock: Crown Cork & Seal.)
At a time when every fund salesman and their dog is hawking ESG, now is a great time to stay away.
William J. Bernstein is a neurologist, co-founder of Efficient Frontier Advisors, an investment management firm, and has written several titles on finance and economic history. He has contributed to the peer-reviewed finance literature and has written for several national publications, including Money Magazine and The Wall Street Journal. He has produced several finance titles, and four volumes of history, The Birth of Plenty, A Splendid Exchange, Masters of the Word, and The Delusions of Crowds about, respectively, the economic growth inflection of the early 19th century, the history of world trade, the effects of access to technology on human relations and politics, and financial and religious mass manias. He was also the 2017 winner of the James R. Vertin Award from CFA Institute.