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 and Cliff Asness’s excellent work on this subject so I’ll just a leave link here and here in case you want to see the financial cost of this investing strategy. The short version is, these strategies underperform in theory and in reality, 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
3) ESG investing puts more money in the hands of bad actors. Point 1 is the most basic arithmetic of markets. A smart indexer decides to own all the firms in the market because we don’t know which firms will perform better or worse. So, when you reduce exposure to certain firms because they aren’t aligned with your moral views then you increase the odds that you’ll earn a lower return. This means that someone else is earning a higher return and potentially investing more of that money into the causes you don’t believe in. You are, in essence, choosing to earn a lower return thereby funding the very types of people you might disagree with.
4) No one knows what a “sin stock” really is. The only strict definition of a company that is “immoral” is something that is illegal. Aside from that, a company that operates a legal business is simply providing a service for someone who doesn’t view that business as morally contemptible. For instance, I have a very old truck that uses gas. I sometimes fill that truck up using XOM gasoline. Some people might find this morally contemptible. I do not.
But this concept gets even more interesting when we consider the way that companies provide their service across time. For instance, XOM is now one of the leading firms in exploring alternative energies. What if, in 100 years, they are the market leader in renewables and no longer engage in fossil fuel production? You would have reduced your exposure to a firm that is innovating and producing beneficial changes in the world because your behavioral biases led you to believe that XOM is currently a bad company. And this is part of what makes active stock picking so hard. We can’t predict how firms will change and how society will view their businesses across time. So, what’s a sin stock to you today or tomorrow might not be a sin stock to someone else today or tomorrow.
I am all for investing morally, but I think it should be done in a way that we can maximize the impact and the fact is, the best place to enact change is in the real economy and not secondary markets. In fact, trying to boycott a stock in the secondary market could be counterproductive to your financial goals which could hurt your ability to do good. So, if you disagree with a firm like XOM then don’t buy their gasoline. But refusing to buy their stock will have little to no impact on their actual business and that’s what will drive their stock price ultimately.
I say you can have your cake and eat it too here. You can own a firm like XOM inside of an index fund, earn the higher average returns, use that extra return to fund the moral operations you prefer AND you can boycott XOM’s operations in the real economy. It’s the best of all worlds.²
¹ – I am not saying that secondary market purchases have NO impact on corporate operations. There are many ways that the secondary market price of a stock could impact the firm. But it’s important to recognize that well operating firms will have high stock prices regardless of how many people boycott the stock because there will always be people willing to overlook the supposedly immoral manner in which those profits are made. And their demand for the stock will, in aggregate, play a much more important role than the irrational sellers. Of course, this is a different story for primary market investments as well as institutions, governments and controlling shareholders who can have a significant impact directly on corporate operations.
² – I’m just gonna sleep in this flame retardant suit for a few weeks. I won’t even take it off when I go to the bathroom. Which is going to be weird because I guess that means I am swimming in this suit. If you know what I mean.
NB – I should add that there are perfectly reasonable arguments for ESG investing. For instance, many governments, charities, religious organizations might have a specific mandate that allows them to allocate to certain entities. Or, perhaps ESG investing just makes you feel good thereby improving your comfort with your portfolio and hence making it more sustainable. As an advocate of behavioral investing I am all for any strategy that makes people feel confident about what they’re doing.