My View On ESG Investing

I write this post with some hesitancy because I suspect that it is going to annoy lots of people. This annoys me because the goal of this post is to emphasize the importance of being objective and emotionally agnostic when we’re investing. I’ll put on my flame retardant suit and see how well I can communicate this view without enraging people. Wish me luck. 

ESG investing (environmental, social and corporate governance) is a hot new space in the investment product landscape. The basic goal of ESG investing is to construct index funds and portfolios that are more morally acceptable. So, for instance, you might think that Exxon Mobil (XOM) is hurting the environment so you construct a portfolio that doesn’t own that stock. Makes sense. Or does it? Let’s explore.

1) ESG investing is more active investing that will increase the probability of lower future returns. We know that the more active average investor must, by definition, earn a lower average return than the less active average investor. So, let’s say you don’t like XOM and all its related energy components in the S&P 500. What you’re doing if you decide to exclude these firms from your portfolio is saying “I think the other 95% of firms in the index will perform better than the index”. This is just active investing by another name. And the odds are you’re incurring higher taxes and fees all along the way when compared to a comparable alternative.

I won’t regurgitate Larry Swedroe’s excellent work on this subject so I’ll just leave this link here in case you want to see the financial cost of this investing strategy. The short version is, these strategies underperform as expected.

2) The secondary market is a bad place to enact change. The intelligent defense of ESG is “by reducing the demand for a stock we can increase its cost of capital and impact its operating performance.” This is true to some degree, but I think this is dramatically overstated. For instance, the firms in the S&P 500 are all large established firms that have more than enough capital to finance their operations. They aren’t using the secondary equity markets to fund their operations. In fact, most firms have so much capital that they’ve been net buyers of stock in the last 50 years. So, this puts the cart before the horse. The better way to think of public companies is to think of them like horse betting. We can bet on the horses, but secondary market purchases are just private exchanges, not cash issuance to firms. As a result, betting on the horses doesn’t change the outcome of the race. Similarly, our secondary market purchases and sales have a far smaller impact on the firm’s operations than we might think.¹

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