Friday, October 26, 2018

Some Thoughts on Environmental, Social & Governance Investing (ESG)

It is still an open question whether ESG investing is more than marketing/packaging by asset gatherers.
And beyond that, it is still an open question whether ESG is a rational approach to achieve the stated goals of its proponents.

Here's our general thinking on the phenomena, from the introduction to January's "The Inherent Conflict Between ESG and Passive Investing" which looked at one of the anomalous facts of the biz:
Over the last couple years we've seen investment shops embrace both passive investing and the Environmental, Social And Governance (ESG) criteria in their marketing material and to a somewhat lesser extent in portfolio construction.

Our typical reader is already way ahead of me on this: going ESG means, by definition, you're not passive and,  by definition, going passive means you're not ESG. It's a tautology; it is what it is.

In June 2017 Matt Levine at Bloomberg View had some related thoughts on index construction and the Governance part of ESG that I've been meaning to post but first, just so our position is clear, we have not seen any academic research that overturns the findings of the Marcin Kacperczyk (now Imperial College London) and  Harrison Hong (now Columbia) paper "The price of sin: The effects of social norms on markets" which we headlined way back in 2007 as:
Moral Judgment On 'Sin Stocks' Means Higher Returns For Vice-Friendly Investors

Until ESG can be shown to, at minimum, equal broader indexes over time (not just for a quarter or a year as sometimes happens) our chosen approach is to pursue the vice afforded by broader exposure and use the excess returns for whatever do-gooder projects strike one's fancy.

It's a variation on John Wesley's Sermon 50, The Use of Money (1744) which contains the admonition:
"Earn all you can, Save all you can, Give all you can" 

So, with Wesley thundering in our ears, here's part of Mr. Levine's June 20, 2017 Money Stuff piece "Bank Relationships and Index Rules Also Bancor, leaky brokers, Martin Shkreli, slot machines and unicorns.":
Which leads us to an FT Alphaville post by Colby Smith, October 24, that addresses the highlighted bit in the intro above:

Moral investments aren't outperforming
This week, the world's largest asset manager went all in on ESG — a set of environmental, social and governance investment criteria that has recently swept through the marketing departments of much of the financial industry. BlackRock announced that it will launch a range of ESG-focused ETFs in the US and Europe that will enable investors "to align their investments with their values and long-term financial objectives."

To justify the move, chief executive Larry Fink recited a favourite claim of recent devotees, including Bank of America Merrill Lynch and Barclays: investors will be better off if they invest sustainably. As he told the FT:
We are going to see evidence over the long term that sustainable investing is going to be at least equivalent to core investments. I believe personally it will be higher.
Unfortunately for Fink, new findings do not fully support this claim.
According to analysis by Renaissance Capital, the relationship between country-level ESG scores and financial performance is weak at best and at worst, non-existent, at least historically.
To calculate the ESG scores, Renaissance Capital's Charles Robertson measured various attributes across the environment, social and governance spectrum.

For the "social" component, he gives a 33 per cent weighting to education, life expectancy and gender equality, and add a 0-10 per cent bonus for democratisation. For "governance," he tracks a variety of surveys, including the World Bank's ease of doing business and Transparency International's Corruption Perceptions Index. On the "environment" front, Robertson factors in carbon emissions and water pollution to varying degrees. Demographics, income inequality and consumer protection are not included.

Now onto the "awkward" part, as Robertson puts it (emphasis ours):
We would love to think that investing in line with ESG principles would both feel good and show up in market pricing. Sadly, we find virtually zero correlation between sovereign bond pricing (using credit default swaps) and ESG scores (obviously after adjusting for per capita GDP) and not much in the equity markets either. Indeed, the best-performing DMs and EMs in 2018 have the worst ESG scores."
Here's one of Robertson's charts showing stock market returns, as measured by the annualised total return of the MSCI index, against changes in the ESG scores:...MUCH MORE 
The comments are also very sharp and on point, this is a topic that is most, ahhh, topical.
A couple of the commenters point out the "ESG equities aren't sovereigns" critique which is prima facie but most of the others go a bit deeper.

Here are some prior posts on ESG:

May 2017
AQR Capital's Cliff Asness on Environmental/Social/Governance (ESG) Investing 
The footnotes are pretty interesting and a possible threat to Matt Levine's hitherto unchallenged fn dominance.
May 2017 
Is Environmental/Social/Governance (ESG) Investing Integration a Fad, or Does It Have Alpha Potential?

August 2014 
Only Now Is the Pax World Global Environmental Markets Fund Again Buying Renewable-Energy Stocks 
It's just been easier and less risky to make the broad market, as opposed to sector, bets over the last few years. 
March 2016
"SHE Power: State Street Launches Gender Diversity ETF"
September 2017
Does An ESG Mandate Mean You Can't Invest In Electric Car Companies Using Cobalt Containing Batteries? 
November 2017 
Hey Mister Environmental, Social, Governance Investor: What the Hell Are You Doing In Bitcoin?
March 2018
Is It Ethical To Deal With Facebook? "Facebook Advertisers Start Pulling Out" (FB)
(in Edward G. Robinson Voice) Where's your ESG now, see?* 
In addition to BlackRock, Vanguard also staked their claim this month with a couple new ETFs which promptly got caught in the downdraft and even underperformed the underperforming indices 

From that April 2007 post (hey, we're nothing if not patient):

Moral Judgment On 'Sin Stocks' Means Higher Returns For Vice-Friendly Investors

That's the headline of a press release from the University of British Columbia's Sauder School of Business announcing the release of a draft paper by the school's Prof. Marcin Kacperczyk and Princeton Economics Prof. Harrison Hong.

Prof. Hong lists his research interests as:
 "Asset pricing with less-than-fully-rational investors; differences of opinion, short-sales constraints and asset prices; social interaction and financial markets; career concerns, biased forecasts and security analysts; organization, performance and mutual funds; asset pricing with asymmetric information and other market imperfections."
Hey! Mine too!