ESG and the complex calculus of public and private goods

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By Clark Troy

In recent years consciousness of climate change and the need for action has become ever broader: witness the recent decisions of Allstate and State Farm to stop selling insurance policies in California due to risk from wildfires.

As this trend has collided with legislatures unable to pass enough laws to move many needles. Investing for Environmental, Social and Governance goals has become one of the biggest trends in finance. One can scarcely turn around without tripping over another article about ESG themes. Certainly, lots of money is flowing into these types of investments. Estimates of just how much money vary, as of course they must, given that there is no precise and universally agreed upon definition of what ESG investing is, but run as high as the tens of trillions of dollars out of a total investable universe in global stock and bond markets of about $400 trillion.

Those investments termed “ESG” almost without exception are designed to advance liberal-leaning goals – we’ll discuss critiques of their efficacy (some reasonable, some less so) and competing investment products aimed at cultural conservatives in a subsequent column.  ESG investments seek to align a person or institution’s investments with their political and social goals by rewarding firms that try to bring about progressive goals through their hiring, internal administration and vendor and supplier sourcing policies. Not easily said, it is nonetheless more easily said than done.

The desire for one’s money to march in line with one’s values is by no means a new idea, but the terms, acronyms and tools for doing so have changed over time. In recent generations the prevailing term of art was “socially responsible investing” or SRI and the primary tools for investing were actively managed mutual funds with relatively high expense structures. Investors could expect to pay management fees of something like 1% for investments in those funds. Investments were chosen by hard-working and earnest professionals and performance varied widely. These SRI mutual funds performed more or less like all other mutual funds, some did quite well, others less well, but investors in these specific funds slept better believing their investments were being managed with an eye toward doing good.

Another term that has emerged in recent decades is “impact investing,” which most often denotes investing to achieve specific, measurable social or environmental goals (build lower-cost apartments in Cary, fund a carbon capture and sequestration startup, preserve forest in Vermont and sell carbon credits) while also getting a decent financial return. By their nature, these types of impact investments have the potential for the most closely observable outcomes, but also the highest costs and risks. At some level they are close cousins of contributing to charitable organizations. They therefore appeal first and foremost to more affluent clients more able to stomach the risk of near total loss of principle.

Over the last couple of decades, as more and more people have chosen to pursue low-cost index-based strategies to reduce their investment expenses, lower-cost ESG index-based mutual and exchange-traded (ETF) funds have emerged in parallel. To keep the costs on these down, portfolios are selected by scorecard-based strategies, which rate companies on such criteria as carbon footprints, hiring and board composition, toxic emissions, etc., instead of being hand-picked by investment managers. So, for example, a scorecard-based ESG index-based ETF from iShares costs 0.25% as opposed to an S&P 500 index ETF costing. 0.03%. One pays more for the ESG screen, but still the overall cost is far below that of most actively managed mutual funds. One continues to pay something to have one’s investments align with one’s beliefs, but less than before.

From a performance perspective, both actively managed investments and their passive counterparts tend to perform in line with their respective non-ESG analogs. Some ESG actively managed funds outperform the market for a while but, like all actively managed funds, fail to do so consistently. ESG-tilted index funds of course perform in line with their constituent elements.

So, for example, since most of them exclude or have dramatically fewer shares of carbon intensive firms like oil and gas producers, ESG index funds may outperform when oil is out of favor but will definitely underperform when the price of oil is rising, as it did after Russia invaded Ukraine. ESG indexes tend, on balance, to be somewhat heavier on technology stocks than their “vanilla” counterparts, so they may outperform when tech rockets higher. Huge rafts of studies have been published on the question of whether ESG investments perform better or worse than non-ESG ones. Meta-studies of the existing research seem to indicate that the impact on performance of adding ESG criteria to an investment process is pretty much neutral.

So, we are left, then, with the actual additional costs of ESG investments themselves, which tend to be something like 1% a year for actively managed funds and closer to 0.2% for passive ones, roughly $10,000 and $2,000, respectively, on a million-dollar portfolio. Do the broad benefits or “public goods” brought about by the investments justify the costs of the funds? Or would one be better off, say, incurring lower investment costs by using the lowest-cost index funds possible and contributing more to non-profits where the impact of one’s dollars is more tangible and auditable?

This is a deeply personal decision. Some would rather manage their investments strictly to maximize economic gain (private goods) and effect public goods by giving money away. Others are comfortable trying to do both, though in the end everyone’s budget is limited in one way or another and each of us can only give up to some level. Ultimately there is no clear answer as to which approach is best, but once we pause to think it through, the strictly economic choice is pretty much the same for all of us. We have to decide whether to spend at least a little more on our investments or spend less and give the savings away.

As indicated above, we’ll return in a future column to discuss some of the moral and ethical complexities around ESG investing and some of the criticisms it has attracted in recent years.

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