ESG Movement: Healthy And Accurate, Or A Scam?
“The latest investor push is to get corporate managers to pay greater attention to ESG issues. This is really about controlling risk and operating businesses to capitalize on opportunities. Whether it leads to financial outperformance is questionable, but ESG funds will remain popular with Millennials and money managers. ”
A major topic in investment circles and corporate board rooms is the issue of environment, social and governance (ESG) metrics. Much like the climate movement’s evolution from global heat measures to now all aspects of unusual climate trends that can be extrapolated to show horrific economic and social outcomes, ESG is rapidly making a similar transition.
The issue of ESG is directed at public corporations, as some offer easy, high-profile targets that help the movement score victories. Leaders in this effort are the mutual funds and exchange-traded funds (ETF) that only invest in companies with high ratings for ESG. Whether these funds actually outperform traditional mutual funds and ETFs has become a battleground for investment experts. However, one wonders whether the promotion of ESG investments is an attempt by money managers (many now publicly traded companies) to capitalize on the generational transfer of wealth underway to concerned youths. Larry Fink, the head of the world’s largest money manager BlackRock, has often highlighted how he expects ESG-focused ETFs will see $400 billion of inflows by 2028, up from $25 billion last year. To capitalize on this trend, BlackRock is planning to dramatically increase the number of ESG oriented ETFs it offers investors as a way to boost its income.
Governance has always provided an attractive target for corporate critics and activists because there have been serious improprieties. Many governance issues arise when insiders and complicit directors engage in actions detrimental to the interests of shareholders, but they are also often detrimental to the interests of other groups – employees and local communities. Many of these violations are uncovered by securities regulators, but it often has taken activist shareholders to highlight them. A beacon leading to activist interest is severe investment under- or overperformance.
While the most blatant examples of governance failures are easy to dismiss as one-offs, the ESG challenge goes well beyond improprieties and to the question of risk management for corporations. Public companies are cautioned to always highlight for investors the risks to its future performance, as protection against lawsuits if something does go wrong. These warnings are usually incorporated in the first slide of investor presentations, and are written in terse legalese and conclude by directing investors to the company’s financial filings with regulators. The “Disclaimer” slide is laughingly referred to by company presenters at investment meetings as “a message from our lawyers,” or “this warning tells you to not believe anything I say during this presentation.”
In financial filings, companies are required to list all the factors that could possibly harm the company’s financial health and its future revenue and earnings performance. The reason for this requirement is for a legal defense if something goes wrong and the company’s share price is significantly damaged. As climate change and social inequity concerns have grown in recent years, the younger population segment (Millennials) has become energized and is demanding that society, governments and corporations address these challenges. For corporations, the pressure is to actively respond by altering how they have been managing and investing, and adopt a management philosophy that incorporates responses to all these social concerns.
Utilizing ESG as an umbrella to capture the social concerns, the financial community is now selling investment products that should appeal to these young, socially-concerned investors. While most investment firms are targeting Millennials, a Wall Street Journal article in late 2019 addressing ESG investing by age groups stated that Millennials are the most vocal about ESG, and have increased their frequency of checking their portfolios for ESG resiliency. But, according to investment brokers, it is Gen Xers who are investing more money in line with ESG guidelines.
Exhibit 17. How Is Most Concerned About ESG? SOURCE: The Wall Street Journal
The hope of investment firms is that as younger investors grow their wealth, plus benefit from the wealth transferred from their Baby Boomer parents, ESG funds will benefit. To support that view, data from Kasasa, a financial and technology services company, shows the generational breakdown by age and their net worth:
Baby Boomers: Baby boomers were born between 1946 and 1964. They're currently between 56-74 years old (71.6 million in U.S.) and have an average net worth of $1,066,000 and a median net worth of $244,000.
Gen X: Gen X was born between 1965 and 1980 and are currently between 40-55 years old (65.2 million people in U.S.). They have an average net worth around $288,700, but the median is $59,800.
Gen Y: Gen Y, or Millennials, were born between 1980 and 1994. They are currently between 24-39 years old (72.1 million in the U.S.) and have an average net worth around $76,200, but a median net worth of only $11,100.
Gen Y.1 = 25-29 years old (around 31 million people in U.S.)
Gen Y.2 = 29-39 (around 42 million people in U.S.)
Gen Z: Gen Z is the newest generation to be named and were born between 1996 and 2015. They are currently between 5-24 years old (nearly 68 million in U.S.). It is difficult to report on this generation, as they have no net worth or career.
Recently, a battle has erupted over the performance of ESG-focused funds. Earlier this year, BlackRock pointed out that sustainable (ESG) investment funds outperformed other funds in the market downdraft due to the Covid-19 outbreak. BlackRock noted: “In the first quarter of 2020, we have observed better risk-adjusted performance across sustainable products globally, with 94 percent of a globally-representative selection of widely-analyzed sustainable indices outperforming their parent benchmarks.” They further stated: “Overall, this period of market turbulence and economic uncertainty has further reinforced our conviction that ESG characteristics indicate resilience during market downturns.”
BlackRock also noted that the market sell-off in March spurred investors to rebalance their portfolios, which included increasing their exposure to ESG. A HedgeWeek article noted that BlackRock highlighted how global sustainable open-ended funds drew $40.5 billion in new assets during 1Q20, a 41% increase year-over-year. The potential for ESG investing growing in the future was reinforced by BlackRock’s statement that “In this volatile environment, investors have been seeking to understand what characteristics contributed to comparative resilience in portfolios and how to incorporate these characteristics in their own investments.”
Data from several investment firms highlight the performance record of sustainable (ESG) investments. While they did not match the market during 2015-2020 (ending April 20), they outperformed non-ESG funds. These funds outperformed both the broad market and non-ESG funds for 2017-2020, and they have produced positive returns for 2020, year-to-date. These funds also did not fall as much as the market and non-ESG funds for February through April 2020. The latter performance would appear to support BlackRock’s view that 94% of ESG funds outperformed the broad market index during the first quarter of 2020.
Exhibit 18. How ESG Portfolios Have Performed SOURCE: Visual Capitalist
The second chart in Exhibit 18 (prior page) shows selected ESG funds offered by Fidelity International (blue) and how they did not decline as much as the broad market or the non-ESG funds during February 19 to March 26, which captured the worst of the stock market downturn this year. With the market having recovered and now reaching new highs, it will be interesting to see how the fund comparisons are at the end of 2020. JP Morgan said that 55% of global investors believe that Covid-19 will be a positive catalyst for ESG investing. That view supports the estimate that $45 trillion of assets will be invested under ESG principles by the end of 2020.
The ESG fund performance claims have come under attack, most recently in a report by four business school professors from both sides of the Atlantic. The professors acknowledged the claims of ESG outperformance.
“‘Responsible investment’ fund managers and ESG data purveyors alike have been perpetuating the reputation of ESG as a resilience factor, with Morningstar even referring to ESG as an “equity vaccine” against the pandemic-induced market selloff (Willis (2020)). For example, for the first quarter of 2020, Blackrock, the largest active investor in the world, reported better risk-adjusted performance across sustainable investment products globally (Blackrock (2020)), Morningstar claimed that 24 of 26 ESG-tilted index funds outperformed their closest conventional counterparts (Hale (2020)), and MSCI boasted that all four of their ESG-oriented indices outperformed a broad market counterpart index (Nagy and Giese (2020)). Following all of this hyping of ESG as downside risk protection, there was no surprise in CNBC’s report that the first quarter of 2020 saw record inflows into sustainable funds (Stevens (2020)). Despite this high level of enthusiasm, however, skepticism is beginning to emerge about whether ESG really serves as a returns shield in times of crisis.”
The comment about skepticism was noted in footnotes, which are worthy of attention. The most relevant footnote stated:
“For example, the Wall Street Journal recently attributed higher ESG firms’ pandemic returns outperformance to luck (Mackintosh (2020)). And a Financial Times article similarly suggested that ESG-titled bond indices’ outperformance during the COVID-19 selloff was not due to ESG per se, but rather because the underlying firms had higher credit ratings and the funds had low exposure to the energy sector that was hit by a contemporaneous crash of historic proportions (Nauman (2020)).”
The professors’ study involved a detailed examination of all the variables that impacted stock performance during 1Q20. The professors described the study:
“We first perform a multiple regression analysis of stock returns during the “crisis” quarter (i.e., January through March 2020). Specifically, we regress buy-and-hold abnormal returns on the firm’s ESG scores, after controlling for numerous other factors such as accounting-based measures of financial performance, liquidity, leverage, intangible asset investments, variables capturing institutional investor interest and shareholder orientation, firm age and market share, the firm’s industry affiliation, as well as a full array of market-based variables that are known determinants of returns.”
The study’s conclusion about the contribution of variables impacting stocks’ performance during 1Q20 is shown in Exhibit 19. The stocks’ risk and growth potential are the variable explaining the largest amount of performance, followed by industry and company financials. ESG, however, only contributed 1% to the performance. That would certainly call into question the belief that ESG variables helped funds and stocks to outperform. As the professors pointed out, many of the outperformance claims are really based on simple pairings of funds, and not analyses holding variables constant to understand what is the contribution of a particular variable.
Exhibit 19. ESG Contributed Only 1% To Performance SOURCE: Professors’ Study
The professors decided to give ESG a second chance, so they conducted a similar analysis for 2Q20, which they considered to be a recovery. Here is what the study concluded.
Exhibit. 20. ESG Meant Little To Rising Share Prices SOURCE: Professors’ Study
As the authors put it, “The results from this second chance test indicate that firms’ ESG scores are significantly negatively associated with returns during the market’s recovery, while their investments in internally generated innovation-related assets are once again positively associated with returns to an economically significant degree.” The results from this period of a rising stock market, coupled with the results during the downturn, certainly point to other company characteristics having greater influence in performance than ESG scores. These results will do little to blunt the ESG movement, and in Europe it is very strong. It recently led one money manager in Norway to sell all its coal and oil and gas stock holdings. They join many other European-based money management firms that are eschewing fossil fuel investments to demonstrate their commitment to ESG.
The major way that ESG is helping to change global corporate culture is via climate change. Having convinced governments that only they can prevent the damages from climate change, politicians have embraced bans on fossil fuels and requirements that future power come from clean energy. As politicians often do, they embrace the broad intent of policy changes, but never investigate the social and/or economic costs and disruption, or, in other words, what the downsides of the policy changes might be. We have seen that shortcoming in California with its rolling electricity blackouts to prevent the entire electric system from crashing during the heat wave, caused by relying too much on renewable power. Proponents of clean energy – solar and wind – are now acknowledging that California doesn’t possess a “smart” electric grid. Such a grid would be able to draw electricity from individual home solar panels and to shut down air conditioners and other large electricity consumers when peak demand arrives. This will take years and cost billions to create. Did they possibly put the cart before the horse?
At the same time these people are bemoaning the lack of a smart grid, they are happy to see subsidies offered to suppliers of clean energy and large power consumers, such as electric vehicles. While similar conditions exist in Europe, their experiences have not received as much media attention as in California. The UK heat wave resulted in a drastic drop in wind power’s contribution, and when the sun went down, so too did electric power supplies. Continental Europe hasn’t experienced a serious heat wave, plus there are many more countries that can provide surplus energy, so they have avoided similar experiences. But, as European economies are on track to reduce, and eventually eliminate, fossil fuel use over the next 20-30 years, traditional energy providers are rethinking their business models and strategies. While many of these managers understand that the clean energy policies being put in place may not be met, they also understand that their fossil fuel demand is being capped, and it will shrink in the future. How quickly the market shrinks is unknown, but it will shrink, until it doesn’t. At the same time, not all countries served by these companies are on the same course, which makes investment decisions tougher to not wind up with stranded assets that destroys financial returns.
Caught in the squeeze between ESG pressures from investors and increased pressure from environmentalists and policymakers to curtail their basic businesses, there aren’t any escape routes. That is why we see those European-based major oil companies leading the charge in curtailing their traditional oil and gas activities and increasing their green energy investments. The result, however, is as Bernard Looney, the CEO of BP plc, warned last February, during his first public press meeting, that green energy investments do not earn returns anywhere close to those of traditional oil and gas operations. As a result, he warned investors in BP stock to recognize that their dividend checks might not grow at the same rate they have in the past due to a greater investment in lower return renewable energy projects.
Lower returns are certainly a risk from the shift to renewables and clean energy investments. While this will play a role in overall investor returns, the push for ESG may have a greater impact. Will companies that don’t screen well on ESG metrics be valued lower than before? Contrarily, those top-ranked ESG stocks might sell in the future at a premium to their current valuations, as investors and fund managers clamor to fill their portfolios with socially acceptable investments. What might these investment shifts mean for executives in how they manage their companies. The professors who authored the ESG study referenced above warned:
“An alternative view of corporate ESG investments suggests that executives may choose to improve their company’s ESG scores at the expense of shareholders in order to build their own personal reputations. From this agency theory perspective, ESG investments are at best wasteful, and probably even harmful to shareholders (e.g., by increasing the propensity for management entrenchment).”
Based on that possibility, it is not inconceivable that managers might actually reduce the resiliency of their companies, while also lowering their ESG credentials. How often is the composition of ESG funds re-evaluated and shareholdings rebalanced? Therein lies a risk to ESG investing. That risk is added to the lack of true ESG standards and complete disclosure of company ESG variables. This lack of corporate disclosure and inconsistency among companies is why investment fund managers in Europe are pushing back hard against the EU’s push to develop the world’s first rulebook for sustainable finance, of which green bonds are expected to be a major component, as well as ESG investing.
The European Fund and Asset Management Association (EFAMA) has written to EU regulators asking for more time for the industry to gather information about the ESG risks in their portfolios. As a central plank of the EU’s push to fund the green transition, the ESG disclosure regulations aim to limit “greenwashing” by forcing asset managers to provide clear information about the sustainability of their portfolios. The rules are to be in place in March 2021, but the EFAMA is asking for a delay until January 2022 at the earliest. They point out that many of the data points required by the regulations are not available, plus companies are unaware of the new regulatory requirements, therefore they do not have the necessary data. The pushback from the investment industry points to the gulf between policymakers’ ambitions for green finance and the thorny reality of implementing a new system from scratch. Once again, a rush to institute policy without considering what it takes to implement it.
While ESG is popular today, the reality is that CEOs and boards of directors pay attention to the welfare of all their stakeholders. It is difficult to deliver outstanding results while mistreating stakeholders. In essence, this appears to be the conclusion of the study by the business school professors. This isn’t the first, nor will it be the last time a popular stock market fad drove investing strategies. With Millennials driving ESG popularity, and they represent the future wealth holders, investment funds are bound to dream up ways to get their hands on that wealth. To a large degree, the clamor over ESG investing may be nothing more than a marketing ploy. The question is whether an ESG investment philosophy shortchanges Millennials when they will need the money to support their retirements.