ESG Investing | Don't Be Fooled
How Right Can Be So Wrong
ESG: Conceptually Simple, But Simply Complex
“ESG” has become an esoteric buzzword in recent years but how, if at all, should we factor it into our investing strategy?
A company that is well managed and which generates durable earnings by deploying capital in a manner that is morally justifiable on both social and environmental grounds must be a good investment.
Conversely, a company that acts in an unethical manner with no moral compass is a high-risk proposition which, all else being equal, ought to be avoided.
However, ESG is all too often being done badly. Too many people are getting it entirely wrong by treating it as a "tick-box" exercise or an algorithmic exercise.
Allow me to take you by the hand and guide you through this mine field by highlighting three golden rules:
Avoid the Zero-Sum-Game
There is no One-Size-Fits-All
Be a Responsible Investor | Set Your Own Goals
1. Avoid The Zero-Sum-Game
Some people accept that anthropogenic greenhouse gas emissions are an existential threat to mankind and so will have an aversion to oil companies that produce hydrocarbon fuel. Others form a view that global warming is no big deal and so they are happy to invest in oil majors.
I have my own view, but that’s a debate for another day. For the purpose of this article I am looking at this dispassionately from an economic viewpoint.
Consider this. To great fanfare a publicly listed fund divests its holdings in hydrocarbon based oil companies in the name of ESG. Is this merely a publicity stunt or is it a benevolent act on the part of the fund manager for the benefit of the planet?
Who do you think that the fund sells its oil company interests to? Private hedge funds are buyers for sure.
A "shift" in ownership is all that has been achieved. The hydrocarbon businesses continue to flourish with new shareholders.
Show me an environmental benefit!
Meanwhile, the publicly listed funds are charging their customers a premium to be invested in ESG Funds. People are being hoodwinked into paying for a clear conscience but nothing else.
The investment fund wins because fees are up. The hedge fund wins because it picked up cheap assets that deliver a good yield. ESG advisory firms win by charging fees to the fools that pay for it.
One man’s gain is anothers loss. The benefit felt by the funds is paid for in cash and opportunity cost by investors. It is they who lose, and for what? There is no environmental benefit.
Professor Aswath Damodaran at the Stern School of Business at New York University has recently launched a scathing attack on the ESG sector:
“I believe that ESG is, at its core, a feel-good scam that is enriching consultants, measurement services and fund managers, while doing close to nothing for the businesses and investors it claims to help, and even less for society.”
Tariq Fancy, formerly BlackRock’s first global Chief Investment Officer for Sustainable Investing (2018-2019), argues that sell-side financial institutions have an obvious motivation to push ESG products given that they usually have higher associated fees. Fatter profits for the service provider invariably mean a haircut on returns received by the investor which creates a conflict of interest.
Fancy, in a recent online essay, says that:
Green Bonds, where companies raise debt for environmentally friendly uses, is one of the largest and fastest-growing categories in sustainable investing, with a market size that has now passed $1 trillion. In practice, it is not totally clear if they create much positive environmental impact that would not have otherwise occurred.
2. There Is No One Size-Fits-All
Each of us has a moral compass, and it stands to reason that there are some investments that we will avoid because it violates our sense of right and wrong. In the same way, ESG is very nuanced and needs to be tailored to each investor
The Russian invasion of Ukraine has certainly put ESG theory to the test. The arms industry has been shunned by the ESG crowd on the basis that it costs lives. But is there not a counter view that the manufacture of arms acts as a defensive deterrent?
Had Ukraine not agreed to nuclear disarmament under the Budapest Accord in the mid 1990s, there is a good chance that Russia would never have invaded, war would have been averted, and hundreds of thousands of lives could have been saved. Is it socially responsible to ostracize the arms industry from capital markets on grounds of ESG?
The truth is that there is no right or wrong answer to this question. As with politics and religion, different people will formulate differing views. It is for this reason that I argue that it simply is not possible to manage ESG objectively with numerical scores.
Tariq Fancy has warned that so much around ESG investing is subjective and that both data and third-party ratings are entirely unreliable.
So, if anyone presents you with an ESG league table or if they suggest that they are leaders in ESG, humour them with a smile and walk away.
Every business needs to formulate its own manifesto and let that be the basis upon which investors decide whether or not to invest capital.
3. Be A Responsible Investor | Set Your Own Goals
The United Nations Principles for Responsible Investment (UN PRI) defines responsible investment as an approach to managing assets that sees investors include environmental, social and governance factors in their decisions about what to invest in; and, the role they play as owners and creditors.
Listed under the headline of “misconceptions” the PRI provides a long list of what responsible investment is NOT.
responsible investment does not necessarily require investing in a specific strategy or product… exactly how an investor practices responsible investment varies widely;
responsible investment does not require sacrificing returns;
responsible investment is not the same as sustainable, ethical, socially responsible and impact investing
opposed to an approach which makes moral or ethical goals a primary purpose, responsible investment can and should also be pursued by the investor whose sole focus is financial performance.
Broadly, when it comes to investing based on non-financial considerations there are six distinct types which are often wrongly conflated:
ESG investing is about incorporating environmental, social and governance information into investment decisions to help enhance risk-adjusted returns. This does not have to be sustainable. For example, an oil and gas company might be considered a good ESG investment if it is offsetting its emissions in its operations, has a strong safety record and is giving back to the communities where it operates. The ESG criteria needs to be objectively measurable.
Socially Responsible Investing (SRI) is where moral investing trumps ultimate returns.
Exclusionary SRI investing includes divesting and/or screening out companies that do not meet specific investment criteria. Examples may include the tobacco industry or gambling.
Inclusionary SRI investing is when the investor positively seeks out companies that meet or exceed thresholds in relation to socially responsible criteria.
Impact investing or Sustainable investing is concerned with bringing about a positive change by virtue of making an investment. This may be by virtue of providing capital to deliver a measurable social and/or environmental objective alongside financial returns. Perhaps investing in renewable energy technology or electric vehicles. Impact is measured on the basis of “intentionality,” “additionality,” “materiality,” and “measurability.” This investment approach is best defined by pursuing the three pillars of sustainability: economic growth, environmental protection, and social progress, also referred to as “people, planet, and profits.” Profits are an important element because it is difficult to sustain anything that is continually loss making. Said differently, sustainability is dependent upon profitability.
Activist investing is where the investor procures change within a company by taking a sizeable stake and exerting influence on the board. This may or may not involve bringing about ESG changes.
Ethical investing is subjective. It is a set of dogmatic rules that apply to a subset of investors but not to the entire investing community. It usually involves people who faithfully adhere to that rule set without question, often based on faith. This includes Islamic finance and Quaker finance.
Know which of these, if any, are important to you and invest accordingly.
Case Studies
I shall demonstrate with reference to two large cap companies how a blind desire to be seen to be doing the right thing in the name of ESG can be disastrous for investors.
A. Unilever (London: ULVR)
Unilever, a multinational which owns a vast array of more than 400 food and household brands including Dove soaps, Rexona deodorant and Ben & Jerry’s ice cream, has self-styled itself as a champion of ESG investment criteria and it emphasizes ethical credentials over traditional financial metrics.
Unilever seems to have taken political correctness to illogical extremes.
The word “normal” is often used to describe what type of skin or hair – such as normal, dry, fine, or oily – is recommended for a particular beauty product. However, it recently announced that it was removing the descriptor “normal” from its soaps, shampoos, and other personal care brands, saying the word was not “inclusive” and had a “negative effect on people.”
Dr Bella d’Abrera from free-market think tank the Institute of Public Affairs was reported in The Daily Telegraph newspaper as describing the move as “ridiculous.” She said “Being ‘normal’ and ‘ordinary’ is not triggering for anyone except for the Unilever marketing department. By desperately trying to be ‘inclusive’ Unilever is alienating the majority of its customers who fall into the ‘normal’ hair category. The folk at Unilever are clearly on another planet…”
This is only one of a number of ridiculous moves that Unilever made in the name of ESG.
In July 2021 ‘Ben & Jerry’s,' a Unilever brand, announced that it would stop selling ice cream in the Occupied Palestinian Territory of the West Bank. Political views should never be conflated with commercial objectives – the two are often diametrically opposed.
The political move was not well received by investors with a different political position, and this culminated in several state pension funds in the US including New York, New Jersey, Florida, and Illinois selling their shares in Unilever for violating their policies against boycotts, divestment and sanctions activities related to Israel.
Terry Smith, the man often described as the English Warren Buffett and founder of London-based investment management company Fundsmith, is a top-10 shareholder in Unilever. He takes issue with Unilever’s approach to ESG. In his annual shareholder letter to his own investors, Smith states, “Unilever seems to be [sic] laboring under the weight of management which is obsessed with publicly displaying sustainability credentials at the expense of focusing on the fundamentals of the business”.
Unilever’s share price under-performed the market in recent years. So the suggestion that blindly being a champion of ESG is good for business is unsupported in fact.
B. Lloyds Banking Group (London: LLOY)
In the name of ESG, Lloyds Banking Group (a British Bank) has committed to becoming a leader in gender diversity and it espouses the belief that companies with a better gender mix will see increased performance and that they make better decisions.
Since 2014 the bank has seen the number of senior management positions held by women rise from 28% to 40% and they strive to reaching 50% by 2025. This end target is based on the fact that 50% is representational of the gender split in the general population.
Whether this decision was made on sound commercial grounds by the Executive Committee or driven by the bank’s public relations division is impossible to know. However, the bank has invested heavily in advertising the fact that it was among the first signatories to the “Women in Finance Charter,” that it has been recognized as a “Times Top Employer for Women” for the last ten years and that it has featured in the “Bloomberg Gender-Equality Index” for the last three years and so you may draw your own conclusions on that question.
When the target was first set back in 2014, the bank established an internal mandate on employment and promotion in order to help it achieve its diversity goal. Essentially, it mandated that women were to be favoured over men until the target was achieved.
There had never been any evidence of discrimination in the business prior to 2014. Ironically, it was the introduction of the gender equality policy that introduced gender discrimination (against men) into the bank. Is this really good governance and socially responsible of the managment of the bank? I think not.
During the period 2014 to 2022 Lloyds Banking Group has produced a very lackluster performance with income from its loan book and trading activities down significantly. This has necessitated a 20% reduction in staff numbers and the value of the business has also fallen by almost one-third based on its market capitalization. Compared to its peers, Lloyds Banking Group has under-performed by quite a significant margin.
There is no evidence of a direct causal link between the introduction of a gender equality policy and the poor performance of the business over the same period. However, this data certainly rebuts the assertion made by the bank that companies with proportionate gender diversity see increased performance.
Conclusion
I hope that this article has offered you a new perspective and a deeper understanding of ESG investing. There is a great deal of white noise out in the market which has the potential to confuse investors. My advice is to be diligent. Open your eyes. Do not invest in a business simply because it gives lip service to ESG. If a company is trying too hard simply to tick ESG boxes, then that is a potential red flag. The company ought to be acting in a responsible manner without forcing the issue. And, last but by no means least, remember, ESG integration is “the practice of incorporating ESG information into investment decisions to help enhance risk-adjusted returns, regardless of whether a strategy has a sustainable mandate.” Financial return should never be sacrificed simply to tick a box.