The following is the foreword to the just-released book, Your Essential Guide to Sustainable Investing, by Larry Swedroe and Samuel Adams. The book is available from the Amazon link on this page.
Almost $22 billion flowed into investment funds with a “sustainable” objective during the first quarter of 2021. According to Bloomberg Intelligence, global assets with presumptive environmental, social, and governance (ESG) objectives may surpass $41 trillion in 2022 and $50 trillion by 2025 (more than a third of the total funds under management). The financial industry has responded by providing a plethora of new ESG funds and by rebranding existing funds. Such funds are advertised as helping to achieve a more sustainable world while enhancing investment returns as well.
There is clearly a strong demand by investors to ensure that their investments are consistent with their ethical principles. In addition to meeting financial goals, there are potential emotional benefits from investing. People want to align their investment strategies with their societal values. It would also be unambiguously advantageous if they could push the firms in which they invest to improve societal outcomes while simultaneously enhancing their financial returns. But do the investment products that advertise themselves as ESG-compliant actually deliver? How do you know if your investments will have the desired social impact? And is sustainable investing really a way to assure investors they can do well by doing good?
Amid all the hype concerning sustainable investing, there has been far too little attention paid to careful analysis of exactly what such investing really entails and what the evidence shows about its effectiveness. There is also far too little serviceable advice for investors who wish to invest sustainably. Adams and Swedroe have brilliantly fulfilled these needs with their highly readable and evidence-based guide for investors. Here they show what sustainable investing is, why one might want to do it, what financial returns have been achieved, and what its impact has been, as well as the pitfalls that exist. They also provide practical investment advice for individuals wishing to build ESG portfolios.
We learn that meritorious investments are in the eye of the beholder. The objectives of faith-based investment funds are far different from those that prize enhancing the goals of fair pay and inclusiveness. The most common and popular of such funds are those with explicit ESG objectives. But even then, the term means different things to different people, and it is difficult for investors to understand exactly what the ESG portfolios actually achieve. To make matters worse, the ESG scores for different companies published by the professional rating services provided to portfolio managers differ materially. Correlations of ratings between different rating services are as low as 0.42. To put that number in perspective, the correlations between the bond ratings of S&P and Moody’s are more than 0.99. ESG raters cannot even agree when they are considering the same attribute, such as carbon intensity. Within the electric utility industry, a company with one of the biggest carbon footprints is Xcel Energy. Xcel is ranked poorly by some raters because it generates a substantial share of its power from coal. But Xcel is the first U.S. utility committed to going 100 percent carbon-free by 2050 and is a leader in building wind generation facilities.
ESG ratings also differ markedly for companies for which carbon footprint is not a major factor. Apple gets a high ESG rating of 73 percent from Refinitiv. S&P Global rates them only 23 percent and close to the bottom of their 22-company industry. Even on the identical ESG component of governance, ratings are not even close to one another. Sustainanalytics considers Apple’s management among the most compliant with the best governance criteria, while MSCI considers its governance score second to last in its peer group.
If carbon footprint and governance are major factors in excluding companies from a broad ESG portfolio, what kinds of companies are favored for investment? Examining the top holdings in the largest ESG mutual funds and ETFs, we find Alphabet (Google’s parent) and Facebook, as well as Visa and MasterCard, prominently featured. These companies have had their fair share of controversies. Would all ESG investors really have their social consciences assuaged by investing in companies that have been found to breach individual privacy and impose exorbitant interest rates?
What about the returns from sustainable investing? The authors do a masterful job of meticulously documenting the existing empirical studies. There is no better survey of the returns from ESG investing. Again, the studies do not suggest a clear conclusion. Some studies report market-beating risk-adjusted returns, while others come to the opposite conclusion. There is no unambiguous evidence that sustainable investing enhances long-run financial performance. Moreover, sustainable funds have higher management expenses that will lower net returns than traditional index funds. The authors do believe, however, that avoiding certain companies can reduce so-called “tail risk” – the risk, for example, that a company that cannot or will not curtail its polluting activities could be severely harmed by government fiat. Thus, ESG investing can be a risk-reducing strategy.
One of the very important insights in this book concerns the differences we should expect between short- and long-run returns. This insight can help explain some of the different empirical results. A heightened demand for ESG-compliant investments can cause share prices to rise and thus enhance the returns of sustainable funds. But then so-called “green” stocks will sell at higher valuation multiples and lower long-run required rates of return. Thus, any short-term benefits will be realized at the expense of long-run performance. Investors who wish to invest sustainably should have reasonable expectations, including a willingness to accept lower long-run returns.
A further important insight concerns the likelihood that an ESG influence on share prices will affect corporate behavior. If ESG-compliant companies enjoy higher share prices and a lower cost of capital, then they will be incentivized to improve their ESG ratings. Thus, a focus on sustainable investing can cause companies to behave in a more positive manner.
Adams and Swedroe then turn to a survey of the empirical evidence on whether sustainable investing is actually making companies more responsible. They cite a number of studies that suggest that ESG concerns by investors have had a positive effect in encouraging firms to take actions that have positive societal impacts, such as reducing their greenhouse gas emissions. There is no clear evidence, however, that disinvestment from unsustainable firms has interfered with their ability to raise capital. It would also be a mistake to conclude that increasing the investments to sustainable companies will be sufficient to allow the country to meet its environmental goals. The most effective way to reduce an economy’s carbon intensity is to change the economic incentive to pollute. This could be accomplished with carbon taxation. Or the government could auction off a limited number of tradable pollution permits. Companies could reduce emissions to avoid the cost of a permit or buy permits if they faced especially high pollution-abatement costs. For those who question the morality of a government selling rights to pollute, there is a good answer: It’s better than giving such rights away.
So what is the best practical advice we can give investors who would like to put their money where their mouth is and would be delighted if they could feel that their investments had a positive social impact? An easy solution would be to purchase one of the broad-based ESG investment mutual funds or ETFs that advertise the claim that you can help save the world and increase your return simultaneously. The problem is that it is far from clear that the holdings in these funds are all worthy of merit. Moreover, such funds are less diversified and more expensive than pure index funds and may well underperform in the long run. In trying to do well by doing good, you may achieve neither objective.
In their final chapter, Adams and Swedroe provide useful practical advice for investors who wish to build portfolios that are consistent with their individual values. While such an undertaking requires hard work, they clearly show the necessary steps and the framework required. The criteria are provided for the selection of ESG investments, keeping in mind the difficulties and pitfalls involved.
My own preference is to favor what they call a “patient approach” of making changes “around the edges” rather than having investors alter their entire portfolios. For example, the core of the portfolio could consist of low-cost, broadly diversified index funds. Then investors could add an allocation to a renewable energy fund or some other funds consistent with the particular themes that are important to them. Whichever alternative is chosen, the authors remind us that due diligence is of overriding importance. It is not easy to be good.
Burton Gordon Malkiel, the Chemical Bank Chairman’s Professor of Economics at Princeton University, has been a popular teacher of generations of students and is responsible for a revolution in the field of investment management. His book, A Random Walk Down Wall Street, first published in 1973, used new research on asset returns and the performance of asset managers to recommend that all investors use passively managed “index” funds as the core of their investment portfolios.