As we started on the journey of aligning our finances with our values, we hoped to find an easy investment such as stocks, ETFs, mutual funds, options or another off-the-shelf offering through Fidelity or Schwab that enabled this alignment. ESG investing seemed to promise us clear environmental, social and governance criteria in the makeup of these funds. Like a growing number of investors this seemed the easiest path to achieve our goals.
One of the first efforts that we undertook with our public portfolio was to try to align all of those investments to more responsible ones - under the umbrella of ESG. When we told the experts that we didn’t feel like our investments were aligned with our values, we were encouraged to “get out of the bad and into the good!”. This seemed like good advice though we wondered a bit why this isn’t a standard practice if it is the right thing to do.
What we now believe is that these ESG easy button options operate like the close door button on an elevator, they don’t actually do good other than making you feel like you are accomplishing something. And worse, there is growing evidence that ESG investing may actually be hurting.
Digging into the details
We started our journey by researching the various funds that were labeled as ESG by visiting their web pages, the Morningstar data on each fund, and articles reviewing the various options. The first surprise came when we dug into the underlying holdings in each of the funds. Whether it was labeled climate-oriented or racial justice-oriented, Microsoft, Apple, Meta, Google and Amazon (MAGMA) stocks made up a large share of the ESG funds that we reviewed.
There really wasn’t much difference between one ESG fund and the next whether it is the NAACP Minority Empowerment ETF with top holdings NVIDIA, Apple, Meta, Amazon, and Tesla or iShares ESG Screened S&P 500 ETF with top holdings Apple, Microsoft, Amazon, NVIDIA, and Google. Fund after fund after fund had the same underlying holdings reflecting some of the top tech companies whose growth is faster than average.
Deep dives like this one highlight the similarities between the S&P 500 sector weights and the Large Cap ESG sector weights. At the time of that report in 2020, Microsoft was the largest holding in 11 of the 12 funds. So are these ratings really highlighting best in class environmental, social and governance organizations or just organizations large enough with high enough returns to obfuscate the negatives?
When companies like Meta who get credit for the comparatively green environmental impact of their servers yet contributed to the genocide in Myanmar, is alleged to connect pedophile networks, and routinely spends multiples more in stock buybacks than customer safety remain in the top ESG holdings we can’t help but doubt the veracity of ESG ratings.
Whether it is Apple with claims of substandard working conditions and isn’t as green as they tell you in their marketing or Tesla in their alleged treatment of their workers we see numerous concerning traits exhibited by the top ESG companies that don't align to our values - or with the promises of ESG.
Bullshit ratings
What is ESG anyway? Ostensibly ESG stands for Environmental, Social and Governance but there really isn’t an agreed upon definition of what each of those drivers mean. Further, there isn’t agreement on what you would measure under each level, how you would rate what you measure and how you would trade off between them.
We are now collecting lots of data but the data is impossible to compare and no one can agree on what is “good” and what is “bad”. Should emissions count more than a couple people of color on their board? Or should a good human rights record count more than avoiding bribery and corruption? And what about shareholder activism? If I avoid the stocks that are not doing well, who will put pressure on them to improve?
As a Harvard paper argued last year ESG ratings are “A Compass Without Direction”.
So we are left with a growing number of ratings agencies each creating their own ratings, definitions and scores and then marketing them to institutions and retail investors to help them guide their decisions. By giving us a score we can then absolve ourselves in our investments because we bought the high ESG score stuff. Yet we don’t believe the scores are at all meaningful.
Yet another good example from a colleague who shared with me that their advisors had purchased Fox Corps stock in their green portfolio. FOXA (Fox Corps) is given a very positive ESG rating from Sustainalytics despite being one of the main drivers of climate change denial in the world. They were completely surprised by this outcome and changed their work moving forward.
We get here because the ratings really are meaningless. Back to that Harvard report - here is a heck of a sentence from their executive summary:
“We find that while ESG ratings providers may convey important insights into the nonfinancial impact of companies, significant shortcomings exist in their objectives, methodologies, and incentives which detract from the informativeness of their assessments.” - ESG Ratings: A Compass without Direction
The ESG ratings may not be informative, but they definitely make you feel good by buying the “responsible thing”.
What about the impact
ESG generally tracks the indexes with a few screens here and there but there is growing evidence that it doesn’t actually help with the environment, social or governance outcomes. In one new study they found that ESG is more than likely hurting the environment rather than helping.
The concern raised in that paper is that by simply removing capital from companies as a punishment you can starve them of the very capital necessary to make the types of shifts we need them to make most rapidly. Denying the capital needed to make the green transition could actually entrench the status quo for longer.
Freakonomics did a great job covering this research and the unintended consequences of ESG investing in this podcast. We recommend giving it a listen.
And we have seen other types of negative impacts from the execution of ESG funds. Because there is little regulation in the sector, billions of dollars of ESG sustainable funds purchased Saudi Aramco bonds funding oil exploration.
There really isn’t an easy button for true impact through investing.
And with the growing backlash against ESG as a category you can expect that any limited pressure that exists for companies today will steadily decline. Lawsuits will demand that companies return to the focus on shareholder value under the banner of fiduciary responsibility even though this will inevitably mean that negative externalities will be considered even less.
Refocusing on what matters
So we became convinced that ESG as a strategy was little more than a marketing narrative designed to capture money or a strategy to avoid risks. As we moved out of that, we wanted to see what we could do to better evaluate where the positive societal impacts are in public markets.
Some really important notes here. First, we believe that investing to improve climate outcomes is critical right now. We are likely close to a climate tipping point that will ravage the world and greatly impact the most vulnerable. We believe we have to act now. Second, we strongly believe in the importance of diversity and DEI practices. What we don’t want is for some poorly defined and measured score to slow down progress on those dimensions.
It is because of those priorities that we are now so frustrated with ESG investing. The standard practices aren’t making the progress that is promised and may slow down positive change. We must act now on these critical dimensions - which is why we have pulled out of these markets and are now focused elsewhere.
In a future post we will also touch on the idea of shareholder advocacy. We see this as distinct and far more targeted than general ESG approaches. We are potentially more interested in the positive outcomes that can happen here.
More to come on that soon.
For more great reading and highlights from above that influenced us:
One of the powerful pieces on this front came from Tariq Fancy, the former CIO for Sustainable Investing at Blackrock. His four part essay challenged the market and underlying thinking around ESG investing from an insider’s perspective. He doesn’t mince words and what he highlights resonates with us.
ESG Ratings: A Compass without Direction presents a deep analysis on the problems inherent in the current ratings systems that many people and institutions use to make decisions around ESG.
Some of the first research on the impacts in “green” and “brown” investing argues that the impact of funds invested in already “green” companies provides little impact while increasing the cost of capital to “brown” firms that we need to transition can in fact slow down those transitions. In essence, capital moving to green firms makes them marginally green while making brown firms more brown: Counterproductive Sustainable Investing: The Impact Elasticity of Brown and Green Firms
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