The Intrinsic Futility of ES(G) Investing
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
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.