ESG Underperformance Will Be Its Undoing

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Commentary 

The underperformance of the latest form of “woke activism” in finance, called Environmental, social, and corporate governance (ESG), will be the strategy’s eventual undoing. We have discussed the many problems with ESG investing in previous posts.

• ESG Invesgting—The Great Wall Street Money Heist
• Wall Street Wins Again As ESG Infiltrates Retirement Plans

In those previous articles, we primarily focused on the excessive expense ratios charged for funds that are essentially duplicates of low-cost benchmark indexes. To wit:

With ESG now all the rage, the “demand” drives product development. However, there is also an understanding of why large asset managers have embraced the strategy so readily—higher fees.

Yes, you too can own an ESG fund that is almost three times as expensive as the S&P 500 index, all for the sake of “feeling good about yourself.”

The chart above compares the Top-10 Holdings of the Blackrock ESG Fund to the S&P 500 ETF. For roughly triple the expense ratio the holdings are nearly identical. Source: ETF.com, Created by Realinvestmentmentadvice.com

While ESG investing was promoted as a way for individuals to “invest with their principals,” in reality it was a windfall marketing scheme by Wall Street firms.

Been There, Done That

In the late 1990s, there was a significant movement by Wall Street to limit investing in “sin” stocks such as gambling, tobacco, etc. Investors initially jumped on board, but when returns failed to match the S&P index, that “fad” died away.

The same occurs today as investors who want to be “woke” are demanding products that make them feel good to purchase. However, just as we have witnessed with the various ARKK ETFs, while you may “feel good” about owning “disruptive” companies, that changes quickly when those companies are no longer performing.

The chart compares the performance of the S&P 500 index to the ARK Innovation Fund. Source: Refinitiv; Created by Realinvestmentmentadvice.com

Such is inherently an issue facing ESG funds. Investors will be willing to pay higher expense ratios as long as they are earning higher returns. However, despite the best of intentions, individuals are subject to emotional biases and ultimately focus on performance.

The performance issue will likely become more prevalent as funds that were already underperforming and losing assets simply rebrand themselves.

“Investment managers and banks are taking advantage of our collective willingness to help fight climate change because the ESG space is, to put it mildly, a zoo,” reports Assaad Razzouk for Eco-Business. “Epic greenwashing is everywhere: Out of 253 funds that switched to an ESG focus in 2020 in the United States, 87 per cent of them rebranded by adding words such as ‘sustainable’ or “ESG” or ‘green’ or ‘climate’ to their names.

None changed their stock or bond holdings at that point.”

Poor management performance isn’t solved by simply rebranding the fund.

Inflation Could Kill ESG

If you believe that inflation is here to stay, then ESG will grossly underperform. While 2022 has been a year of “inflation” concerns by the Fed, the underperformance of ESG relative to the energy sector has been quite profound.

“As Deutsche Bank’s Jim Reid puts it, ‘one of the side effects of the hawkish pivot from the Fed in 2022, that continued this week’ is that it could finally crack the facade of ESG and make January a catastrophic month for ESG investors; this is shown in Reid’s Chart of the Day which lays out the 1-month rolling difference between S&P 500 Energy sector returns and the NASDAQ,” ZeroHedge reported last month.

Source: Refinitiv/RealInvestmentAdvice.com 1-month rolling differentials between the MSCI Energy Index and the Nasdaq 100 index.

However, that underperformance didn’t just start in January of 2022. In 2021 the surge in money supply led to increasing rates of inflationary pressures. As we showed previously, inflation is currently running well above the Fed’s target inflation rate.

The chart shows the difference between inflation as measured by CPI and the Federal Reserve’s 2% target inflation rate. Source: St. Louis Federal Reserve; Created by Realinvestmentmentadvice.com

Not surprisingly, that inflationary surge showed up at the gasoline pump as oil prices shot up. As a consequence, and of no real surprise, investors dumped ESG funds in favor of “dirty energy.”

As shown, the SPDR Energy Sector ETF (XLE) has vastly outperformed not only the S&P 500 index, but some of the leading ESG funds from BlackRock, Vanguard, and IShares. Which would you have rather owned?

Source: Refinitiv; Created by Realinvestmentmentadvice.com

ESG investing may be great for headlines, but when it comes to investors it is all about performance.

Want to Be ESG, Plant a Tree

Here is another problem with ESG investing—it makes NO difference to the environment.

Think about how mutual fund investing works for a moment.

An investor buys shares of a mutual fund. The fund manager, in turn, purchases shares of the underlying investments from the open market. The underlying companies receive no capital from the transaction, nor are they aware a transaction occurred.

In this scenario, how were carbon emissions reduced? Were trees planted? Did companies take a different direction with their management teams? Of course, not.

If you want to be a socially responsible investor, there is only one way to achieve that goal. You must invest directly in private startup companies that are tackling climate change effectively. Once a company is public, all you do is trade dollars for another investor’s shares. As noted, that transaction has zero impact on the environment or the company.

As Seth Levine concluded in his treatise on ESG:

“ESG frameworks are entirely superfluous. Simply follow the profits to find those companies enhancing humanity the most. Profits reflect the moral evaluations of billions of customers around the world voting with their hard-earned money. The good financial performance sought by investors can only result from strong value creation.”

“ESG designations are also counterproductive,” Levine adds. “The freer the market the more purely profits indicate ethically good companies. Deferring to a handful of groups, committees, and organizations is not only inefficient but narrow-minded and potentially morally corrupt. It creates a system ripe for gaming by the biggest, the most connected, and those with the most resources to spare.”

Ultimately, investors always seek out investment performance over time, As such, ESG investing will either evolve or give way to a new breed of “sin stocks.”

I suspect that Wall Street will win whichever way it eventually turns out.