Should ESG Investing be Criminalised?

Hmm.
Taken
literally – for
how
else
should
legislation
be
taken? –
that
provision
forbids
New
Hampshire
officials
from
investing
the
state’s
monies
with
portfolio
managers
who
pay
“any
regard
whatsoever”
to
“governance
criteria”.

If
investment
professionals
are
bothered
that
a
company
appointed
the
chief
executives
relatives
to
its
board
of
directors,
or
flunked
a
cybersecurity
audit,
they
cannot
act
on
those
matters
without
endangering
the
New
Hampshire
official
who
selected
them.

(It’s
worse
than
that.
The
bill
states
that
those
who
invest
on
behalf
of
the
state
of
New
Hampshire
may
not
pay
governance
issues
“any
regard.”
Per
the
proposal’s
wording,
portfolio
managers
may
not
even think about
such
topics.)

Further
Problems

The
environmental
and
social
provisions
aren’t
much
better.
Presumably,
the
bill’s
authors
seek
to
prevent
stocks
from
being
selected
because
their
organisations
are
deemed
by
the
portfolio
managers
to
be
“good
corporate
citizens.”
But,
again,
the
bill’s
language
is
overly
broad.
Thus,
whether
a
company
might
pay
steep
fines
for
pollution
or
face
an
impending
labour
strike
would
be
off-limits.

If
there
were
any
remaining
doubts
about
this
proposal’s
sanity,
the
severity
of
its
penalty
should
erase
them.
The
bill
reads:
“it
shall
be
a
felony
punishable
by
not
less
than
one
year,
and
not
more
than
20
years
imprisonment”.
Well,
now.
The
maximum
permissible
sentence
in
New
Hampshire
for
kidnapping,
first-degree
assault,
or
sex
trafficking
is 15
years.

Apparently,
none
of
those
crimes
are
as
depraved
as
permitting
a
portfolio
manager
to
invest
through
ESG
principles.

The
Underlying
Issue

Its
drawbacks
aside,
the
bill
raises
a
legitimate
point:
what is the
outlook
for
ESG
investing?

Those
who
sponsored
the
legislation
imply
the
ESG
mindset
is
doubly
harmful,
in
that
it
lowers
a
portfolio’s
return
while
increasing
its
risk.
The
state’s
officials,
they
assert,
possess
a
fiduciary
duty
to
“maximize
financial
returns
and
minimize
risk.”
But
state
representatives
are
generalists,
not
subject-matter
experts,
and
their
viewpoints
in
this
instance
are
decidedly
partisan.

Let’s
consider
instead
what
impartial
researchers
believe.
By
and
large,
they
ignore
the
prevailing
discussions.
The
common
debate
about
ESG
investing
consists
of
proponents
arguing
that
considering
ESG
factors
avoids
future
woes,
while
detractors
argue
that
addressing
such
concerns
harms
profitability.
ESG
is
“all
about
woke
diversity,” said Home
Depot
(HD) co-founder
Bernie
Marcus.
“Things
that
don’t
hit
the
bottom
line”.

This
is
an
old
controversy
recast.
Long
before
ESG
existed,
business
school
professors
debated
whether
American
businesses
paid
too
much
attention
to
current
profitability,
too
little,
or
just
the
right
amount.
Running
a
corporation
inevitably
involves
trade-offs:
how
much
to
spend
today
to
avoid
tomorrow’s
problems?
For
that
question,
the
accepted
answer
is,
“it
depends.”
The
dispute
cannot
be
resolved
by
theory.

Potential
Objection
1:
Lower
Risk
=
Lower
Returns

There
are,
however,
more
substantial
critiques
of
ESG
investing.
One
involves
taking
the
claims
of
ESG
proponents
at
face
value.
If
evaluating
ESG
issues
is
merely
another
form
of
risk
control,
then
funds
that
invest
with
ESG
principles
in
mind
will,
on
average,
own
less-risky
stocks.
But,
comes
the
reply,
since
risk
and
return
are
related,
with
higher
risks
generating
higher
expected
returns,
ESG
funds
will
make less money
than
their
competitors.

Fair
enough.
This
argument,
however,
undercuts
the
New
Hampshire
proposal.
There
is
nothing
incorrect
about
investing
in
securities
that
have
lower
expected
returns
because
they
carry
lower
risk.
If
there
were,
only
portfolio
managers
who
invested
in
extremely
speculative
securities
would
be
permissible.
For
example,
it
would
be
illegal
to
invest
in
blue-chip
US
equities,
because
emerging-markets
stocks
have
greater
risks
and
therefore
superior
expected
returns.

It
should
also
be
noted
that
the
link
between
such
theory
and
practice
is
extremely
tenuous.
Although
the
precept
is
credible
if
all
things
were
equal,
all
things
are
rarely
equal.
Thus,
its
explanatory
power
is
weak.
For
example,
blue-chip
US
equities
have
whipped
emerging-markets
stocks
in
recent
decades.

Potential
Objection
2:
Higher
Popularity
=
Lower
Returns

Another
objection
to
investing
on
ESG
principles
is
that
because
so
many
investors
are
attracted
to
companies
with
high
ESG
scores,
the
prices
for
such
securities
are
inflated.
Thanks
to
their
popularity,
their
past
performances
have
been
strong,
but
their
future
returns
will
be
weaker.
Pay
more,
get
less.

This
argument
is
rational
too.
It
would
certainly
apply
if
the
facts
supported
it.
That,
however,
is
far
from
clear.
For
example,
when
Morningstar
conducted
an in-depth
study of
global
equities,
covering
the
11
years
from
2009
through
2019,
it
found
stocks
with
the
best
ESG
scores
were cheaper than
their
competitors.
On
average,
they
had
both
higher
dividends
and
lower
price/earnings
ratios.

In
addition,
while
logically
sound,
the Popularity
Asset
Pricing
Model is
difficult
to
implement.
After
all,
before
stocks
lag
because
they
have
become
too
costly,
they
outperform
while
becoming
overpriced.
Is
ESG
in
the
first
stage
or
the
second?
The
question
is
unanswerable.

What’s
more,
if
the
answer
is
that
ESG
stocks
still
occupy
the
first
stage,
then
their
expected
returns
are
relatively high,
not
low.

Potential
Objection
3:
Actual
Performance

Because
so
many
parties
(including
a Morningstar
subsidiary…)
publish
ESG
risk
scores,
and
because
investments’
performance
can
be
measured
over
many
periods,
for
many
countries,
people
can
reach
whatever
conclusion
they
wish.

And
since
ESG
investing
is
both
a
highly
politicised
topic
and
one
that
can
potentially
generate
substantial
profits
for
its
proponents,
that
is
in
fact
what
has
occurred.
Either
side
has
issued
reports
that
appear
to
validate
their
beliefs.

I
will
therefore
set
those
studies
aside.
No
doubt
many
are
estimable,
but
as
they
yield
conflicting
results,
I
conducted
my
own
investigation
instead.
I
sifted
among
all
large-blend
US
equity
funds
with
five-year
track
records
(longer
would
have
been
preferable,
but
few
ESG
funds
existed
a
decade
ago),
sorting
them
into
four
camps:
1)
index
non-ESG
funds;
2)
index
ESG
funds;
3)
active
non-ESG
funds;
and
4)
active
ESG
funds.

I
hoped
to
present
four
results,
but
I
could
not
fairly
do
so.
The
index
non-ESG
funds
contained
several
“low-volatility”
funds
that
tinkered
with
the
conventional
strategy,
thereby
reducing
that
group’s
return.
Instead,
I
opted
to
show
the
industry’s
two
largest
index
funds,
Vanguard
Total
Stock
Market
ETF
(VTI) and
Vanguard
S&P
500
(VOO).
Since
Vanguard
also
offers
an
indexed
ESG
investment,
Vanguard
ESG
US
Stock
ETF
(ESGV),
I
included
that,
too.

(I
omitted
risk
measures,
because
Potential
Objection
1
notwithstanding,
the
standard
deviations
of
returns
for
all
groups
were
similar.)

The
outcome
is
an
investment
Rorschach
test.
If
you
see
victory
for
either
ESG
funds
or
their
rivals,
that
is
what
you
wish
to
see.
One
side
won
the
indexing
battle,
the
other
side
won
the
active
battle,
and
in
neither
case
were
the
results
significant.
No
conclusions
can
be
drawn
from
such
modest
differences.

Now,
if
you
wanted
to
revise
New
Hampshire’s
bill
to
imprison
officials
who
hire
active
portfolio
managers…

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