In light of Milton Friedman’s declaration that “the business of business is business,” one might question whether the efforts companies make through their ESG efforts are evidence of maximizing profits and shareholder value, real corporate social responsibility, or simply good marketing.1 Before addressing this question, it is important first to understand that the complexity of the ESG ecosystem and the number of players involved makes it hard to judge the claims of asset managers purporting to incorporate ESG issues into their investment decisions.2
Who Could Profit From ESG?
There are many layers to the ESG ecosystem (such as asset managers, investment banks, research houses, global standard producers, banks, financial advisors, financial consultants, proxy advisors, rating agencies, market data providers, wealth managers, pension funds, administrators, law firms, ETF manufacturers, insurers, accounting firms, auditors, securities exchanges, and the media to name a few). Each one is looking to make money from ESG investing.3 If ESG investing is “the research and investment strategy framework that evaluates environmental, social, and governance factors as non‐financial dimensions of a security’s valuation, performance, and risk profile,”4 then, unless investors have chosen to invest in an explicitly passive index‐tracking option, they expect their investment professionals to be actively engaged with the boards and managers of companies that their money is invested in. Unfortunately, what investors think they may be getting from their asset manager and what they actually get may be two very different things entirely.5
A Tipping Point For Companies
This is also true for the companies these investment managers invest in on their client's behalf. Formal recognition by major corporations of their ever‐evolving responsibility to society reached a significant milestone in August 2019, when 181 of 188 CEO members of the influential Business Roundtable signed and published “Our Commitment— Statement on the Purpose of a Corporation.” The message these captains of industry were making was clear—business must be broader than just maximizing shareholder value and must consider all stakeholders.6
All Talk, No Action?
But many of these corporate leaders may have made these commitments without having a clear plan on how to achieve them. They have failed to recognize who their stakeholders are or what they would do if their expectations were not met.7 Senator Elizabeth Warren declared in 2019 that this Business Roundtable pledge was “weak and meaningless” and “just a publicity stunt.”8 If this is true, company leaders touting their compliance to ESG without understanding and carefully considering who their stakeholders are, what they expect, and how they might express their disappointment is a tactical path to reputational liability.9 Unfortunately, there seems to be no end in sight as companies compete for the highest ESG marks just to please the investment community. Still, they do so at the potential cost of disappointing those stakeholders they are hoping to appease. This could lead to lawsuits and a damaged reputation that could, directly and indirectly, impact the bottom line.10
Do Investors Have to Sacrifice Investment Returns for ESG Investing?
Key to this discussion about ESG investing is the conversation about performance. A recent study completed in 2017 by Riedl and Smeets found that investors that engage in ESG investing are motivated more by the potential social impact that their investments make rather than the financial implications of their decisions.11 It was also found that ESG investors expect to earn lower returns on their investments than on more conventional funds. The study further concludes that these investors are willing to forgo financial performance to invest according to their social preferences.12 But is this really true? Do investors need to earn lower returns to achieve a social impact?
In 2018, Morningstar released a report that suggested, on average, that ESG funds outperform their conventional counterparts on a relative basis. The report stated that 63% of ESG funds finished in the top half of their respective categories, including 25% in the top quartile, 57% ranked in the top half of their categories over the trailing three years ended in 2018, and for the trailing 5‐year period, 58% ranked in their category’s top half.13 This seems to support the argument that companies with a strong ESG focus tend to be higher quality, lower‐volatility companies that hold their own in up markets and outperform in down markets, thus leading us to the conclusion that investors do not have to sacrifice returns to embark on an ESG investment strategy.14 But for every pundit that supports ESG investing, just as many seem to think that ESG investing is just a flash in the pan. As one opponent suggested:
“In recent years, ESG‐related investments have consistently outperformed their counterparts. That, however, could be an accident—many ESG funds invest heavily in tech companies, and tech most likely is rallying for reasons that have nothing to do with ESG. Many ESG funds exclude fossil fuel investments, but fossil fuel investments could also be doing poorly for reasons that have nothing to do with ESG. Look closely, and it appears that ESG is just another old‐fashioned stock market bubble…One of the big criticisms of ESG is that the criteria for determining which companies are trying to do the right thing are overly broad and subjective. Each ESG rating agency has its standards and weights for ESG factors. It’s pretty alarming that billions of dollars are being allocated subjectively when everything else in the financial world is quantified…ESG is nothing but a fad, not unlike smart beta, the BRICs, structured products, or any of the myriad market bubbles over the last 25 years….”15
Here To Stay
But despite these differences of opinion, there is some support to suggest that ESG investing may allow investors to further both their economic interests and a cause that matters to them without having to accept subpar returns to support their beliefs.16 If the trillions of dollars flowing into these ESG investments in recent years are any indication, ESG investing is here to stay. Furthermore, with respect to how well‐known ESG investing is to the general public, a 2021 survey of defined‐contribution plan participants by Schroders found that 40% did not know whether their employer’s plan offered ESG investment options. But 69% of the members of that same group, along with those who said their 401(k) plan did not offer ESG investment options, said they would or might increase their overall contribution rate if offered ESG options. Only 31% said they would not. Furthermore, that same survey found that among participants who were aware of their ESG options, 9 out of 10 said they invested in them.17 As Deb Boyden, the head of Schroders’ U.S. Defined Contribution Group, suggested when referring to this 2021 survey of defined‐contribution plan participants, “Offering plan participants ESG investment options, and providing greater plan communications about them, would not only appeal to purpose‐minded investors but also could help to motivate some participants to save more toward their retirement.”18
I hope you enjoyed the seventh post in our series on Environmental, Social, and Governance (ESG) investing. Check out other posts in the series here:
(1) Yamada, M. (2019, June 13). “Is Corporate Social Responsibility Just a Marketing Ploy”. Retrieved from Advisor’s Edge: https://www.advisor.ca/columnists_/mark‐yamada/is‐corporate‐social‐ responsibility‐just‐a‐marketing‐ploy/.
(2-5) McDonald, B. (2020, May 18). “Is ESG Investing Just Marketing Spin?”. Retrieved from ESG Research Newsletter: https://esgresearch.substack.com/p/is‐esg‐investing‐just‐marketing‐spin.
(6, 11-14 ) Tucker III, J. J., & Jones, S. (2020, May). 'Environmental, Social, and Governance Investing: Investor Demand, the Great Wealth Transfer, and Strategies for ESG Investing". Retrieved from Journal of Financial Service Professionals, Vol. 74, No. 3, pp. 56‐75 : http://web.b.ebscohost.com/ehost/pdfviewer/pdfviewer?vid=57&sid=b7df3d85‐27da‐4302‐ aebd‐c3477874b215%40pdc‐v‐sessmgr02.
(7-10) Kossovsky, N., & Williamee, D. (2021, May). "Beware the Sirens of Environmental, Social and Governance Investing". Retrieved from Best's Review, Volume 122, Issue 5, p. 48‐50.
(15) Dillian, J. (2020, October 5). "ESG Investing Looks Like Just Another Stock Bubble". Retrieved from Bloomberg, L.P.
(16) Broadridge Investor Communication Solutions, Inc. (Accessed 2021, April 23). "Growing Interest in Socially Responsible Investing". Retrieved from https://www.broadridgeadvisor.com/kt/HtmlNL.aspx?pvw=A9FDFD0F708BBE2F96665A46E3B8F 96BC712956751ACE7A5BACA6AB6F4AA678EA2B%E2%80%A6.
(17, 18) InvestmentNews. (2021, May 13). "ESG Options in 401(k)s Could Boost Contributions, Schroders Finds. Retrieved from InvestmentNews: https://www.investmentnews.com/esg‐options‐in‐401ks‐ could‐boost‐contributions‐schroders‐finds‐206432.
The views expressed within this newsletter are subject to change at any time without notice and are not intended to provide specific advice or recommendations for any individual or on any specific security or strategy. This material has been distributed for informational purposes only. All investments carry certain risk and there is no assurance that an investment will provide positive performance over any period of time. Because ESG criteria excludes some investments, ESG strategies may not be able to take advantage of the same opportunities or market trends as those that do not use such criteria. John Chichester is an Investment Advisor Representative with Dynamic Wealth Advisors dba Chichester Financial Group LLC. All investment advisory services are offered through Dynamic Wealth Advisors.