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ESG Does Neither Much Good nor Very Well
There’s little evidence that the benefits to mankind make up for lower returns on your investment.
By Terrence R. Keeley
Trillions of dollars have poured into environmental, social and governance funds in recent years. In 2021 alone, the figure grew $8 billion a day. Bloomberg Intelligence projects more than one-third of all globally managed assets could carry explicit ESG labels by 2025, amounting to more than $50 trillion. Yet for a financial phenomenon this pervasive, there is astonishingly little evidence of its tangible benefit.
The implicit promise of ESG investing is that you can do well and do good at the same time. Investors presume they can make a market return while advancing causes such as lowering carbon emissions and income inequality. But multiple studies find ESG strategies are doing little of either. Bradford Cornell of the University of California, Los Angeles and Aswath Damodaran of New York University reviewed shareholder value created by firms with high and low ESG ratings—scores provided by professional rating agencies. Their conclusion: “Telling firms that being socially responsible will deliver higher growth, profits and value is false advertising.”
What Messrs. Cornell and Damodaran found at the micro level is also apparent on a macro basis. Over the past five years, global ESG funds have underperformed the broader market by more than 250 basis points per year, an average 6.3% return compared with a 8.9% return. This means an investor who put $10,000 into an average global ESG fund in 2017 would have about $13,500 today, compared with $15,250 he would have earned if he had invested in the broader market.
Did the forgone $1,750 somehow do $1,750 worth of good for mankind? Apparently not. A new report from researchers at the universities of Utah, Miami and Hong Kong finds there is “no evidence that socially responsible investment funds improve corporate behavior.” But this shouldn’t come as a surprise. The same outcome followed decades of investors avoiding so-called sin stocks—alcohol, tobacco, firearms and gambling. In doing so, investors sacrificed returns while the behavior they disapproved of continued. Impact investors want their capital decisions to create outcomes that wouldn’t have existed otherwise, not perpetuate the status quo.
ESG and anti-sin investing have failed for the same reason: Divestiture is an ineffective tool for generating excess returns and changing societal outcomes. It does the exact opposite of what it intends. Divestiture raises returns for the shareholders who remain invested and removes shareholders who are inclined to fight for corporate reforms. As a broad thesis, it’s best to assume that products and services that can be legally and profitably delivered will be, no matter how much others disapprove of them. This includes fossil fuels. The production of goods and services declines when people stop buying them—not when others stop investing in the companies that produce them.
So what needs to change about ESG investing? To start, all ESG funds should provide impact reports with their financial returns. These reports should highlight the funds’ specific “additionality,” detailing the benefits it created that wouldn’t have emerged otherwise. Such impact funds and reports do exist—especially in fixed income—but are a very small fraction of the overall ESG public equity market.
More fundamental makeovers are needed. Composite ESG scores—which attempt to summarize all material ESG risks into a single number or grade—convey little actionable investment information. “I have not seen circumstances where combining an analysis of E, S and G together, across a broad range of companies with a single rating or score, would facilitate meaningful investment analysis that was not significantly overinclusive and imprecise,” said former Securities and Exchange Commission Chairman Jay Clayton during a March 2020 SEC hearing. A case in point: Tesla’s current ESG scores by two leading rating agencies are below those of Pepsi. Does this mean electric vehicles are worse for the planet than soft drinks, or that socially concerned investors should overweight Pepsi and underweight Tesla in their portfolios?
No investment strategy, ESG or otherwise, can be any better than the data on which it is based. This is particularly true for the “S” in ESG. Social mores are constantly shifting.
Comparing credit and ESG ratings illustrates how much work lies ahead for ESG analytics. Broadly accepted financial accounting practices have enabled competing rating agents such as Fitch, S&P and Moody’s to reach similar credit evaluations 99% of the time. The same can’t be said for their ESG counterparts, such as MSCI and Sustainalytics. In a recent paper, researchers Florian Berg, Julian Kolbel and Roberto Rigobon found ESG scores among leading rating agencies correlated only 54% of the time—or barely one in two. ESG ratings are all over the map because the underlying assumptions, methodologies and data inputs vary widely among ESG rating agents.
Another area of ESG ripe for reform: disclaimers. At the end of long advertisements for popular sustainable investment funds, you’ll often find some like the following: “There is no guarantee that any fund will exhibit positive or favorable sustainability characteristics.” We pay more for organic food precisely because we believe it has desirable, verified characteristics. If sustainable investment funds can’t be expected to exhibit favorable sustainability characteristics, they should be called something else.
ESG draws scorn from the left for being too timid and from the right for being too aggressive. The harder truth is that ESG is largely failing on its own terms. Despite tens of trillions of ESG investments, investors haven’t done very well nor generated much good. ESG advocates need to do better or stop claiming they can.
Mr. Keeley is chief investment officer of 1PointSix LLC and author of “Sustainable: Moving Beyond ESG to Impact Investing.” He was a senior executive at BlackRock, 2011-22.
