Aswath Damodaran: It’s Time to Retire the ESG Concept
The fiercest adversary of investing based on environmental, social and governance (ESG) is Aswath Damodaran. ESG is a failure, its advocates are to blame, and the concept should be retired, according to Damodaran.
Damodaran is a professor of finance at the Stern School of Business at New York University, where he teaches corporate finance and equity valuation. He was a keynote speaker yesterday at the Morningstar Investment Conference in Chicago.
Damodaran is known as the “dean of valuation” for his analysis of security prices. He touched on the topic of valuations, but his most provocative remarks were about ESG.
Once the “S” was put in the middle of ESG, the concept was doomed, he said. It is impossible to achieve a consensus on any social issue, much less the full range of socially responsible concerns that permeate the ESG landscape.
Indeed, the fundamental issue for Damodaran is that there is no consensus about what constitutes “good” or “bad” companies when it comes to ESG. (We have written about this issue in Advisor Perspectives.)
Advisors are putting trust in a scoring system that companies will “game,” he said. “We created a scoring system that makes us feel we are doing good rather than a system that does good.”
“The best thing would be to retire the concept,” he said.
Damodaran said that ESG proponents oversold the concept when they claimed that ESG could deliver excess returns (alpha) along with values-based portfolio construction. A constrained strategy (like ESG) cannot beat an unconstrained one. The positive alpha that has benefitted some ESG investors is a result of outsized flows into those strategies, driven in part by aggressive asset management marketing.
Once those flows subside, returns from ESG investing will suffer.
“If your clients think they can earn alpha,” he said, “bring them back to reality. You can’t claim ESG is always good for returns.”
The way ESG is packaged stands in for what advisors and investors should be doing. He accused the investing public of “abdicating responsibility” for making good investment decisions.
Companies are playing “word games” to appease ESG investors, he said, and consumers are getting cynical. The result is that good companies are getting lumped in with the rest.
Advisors should counsel clients by asking for their definition of ESG. Find out why clients are interested in ESG. Is it climate change, gun control, privacy, or other issues? Financial advisors need to understand clients’ definitions and priorities of values.
“There is no one definition,” he said. “It is your job to match a portfolio to your client’s values.”
Ask clients if they are okay with not earning the alpha. Do they want to make the world a better place? If so, ask what their metric of goodness is. What they value may not be built into the ESG score used by fund managers.
Direct indexing is a way advisors can deliver an acceptable ESG solution, according to Damodaran. Advisors can create a portfolio that tracks an index but is customized to eliminate offensive stocks or overweight favorable ones.
Regulating ESG investing will be ineffective, Damodaran said. Instead, regulations should focus on individual companies, forcing them, for example, to disclose their carbon footprint.
Damodaran does not trust corporate CEOs. We need to trust governments, he said, and trust the institutions that should be enforcing proper regulations.
“Regulate the companies,” he said, “not the ESG.”
Asset management efforts to achieve better ESG solutions have been ineffective. He cited the example of Engine No. 1, which successfully placed two directors on the board of Exxon Mobil and constructed its fund to match the S&P 500, but with ESG-driven proxy voting. All that accomplished, according to Damodaran, was to push fossil fuel production away from public to private companies, which are more opaque and harder to regulate. Despite the efforts of ESG advocates, the percentage of energy derived from fossil fuels has remained steady at 82% over the last decade.
Investors can put pressure on companies to achieve ESG goals, but Damodaran is skeptical it will work. Unless consumers cooperate, investment-side pressure won’t work, he said.
Investing cannot be a vehicle for creating change, he said. There are only a small number of companies that are affected by pressure, and they don’t include private or foreign-based firms. That pressure will merely “push the bad behavior behind the curtain,” he said.
Eric Hofer, a great American thinker, once wrote that, “Every great cause begins as a movement, becomes a business, and eventually degenerates into a racket.”
Damodaran has put ESG in the same context: “These ideas start by repackaging an existing concept or measure and adding a couple of proprietary tweaks that are less improvement and more noise. Then they get acronyms, before being sold relentlessly.”
“We want to make the world a better place,” Damodaran said, “but is this the way to do it?”
Robert Huebscher is the founder of Advisor Perspectives.