The Looming Demise of ESG and Virtue Investing

The White House has recently issued a regulation allowing investment fiduciaries, like 401(k) managers, to offer investment options “that consider environmental, social, and governance (ESG) issues, such as climate change and social justice initiatives,” Justin Haskins reports at Fox News.

“Some workers may not notice any changes to their 401(k) and other retirement options over the next year or two,” he continues, “but others will soon find themselves stuck choosing between a short list of ESG-focused investment funds.”

The Biden administration insisting that “good investment decisions should take climate change and other ESG factors into account” creates a massive ethical problem for the financial industry.  A 401(k) manager would find incredible difficulty in both restricting plan participants to ESG offerings and acting as a fiduciary on participants’ behalf. 

For a retirement plan fiduciary, which funds are available in the plan and which are excluded often comes down to two basic factors -- cost and performance.  As most 401(k) investors would certainly prioritize lower costs and better performance over a high social credit score, the 401(k) manager, as a fiduciary, has a responsibility to seek lower cost fund options that provide greater potential for return on investment.

As an investment strategy, ESG fails on both fronts. 

The first is the higher cost of funds employing the strategy.  The cost of a mutual fund is often a function of the complexity of the fund’s management.  This is why a large cap index fund which does little more than hold the stocks of companies in the S&P 500 will cost very little to the investor looking to track the index’s performance.  An emerging market fund, which requires fund managers to relentlessly research and appraise the value of international stocks in lesser-developed nations for the greatest potential return, will often cost many times what the indexed fund does.

The management cost evaluation for ESG funds, however, is different.  They often hold, for example, domestic large cap stocks, which should signify lower management cost to investors.  But because there are additional administrative costs in analysts’ researching and measuring things like diversity of skin colors or genders among a particular company’s board of directors, the cost of investment necessarily climbs with ESG funds.

In the presence of increased cost, a fiduciary acting in the best interest of plan participants should be able to argue that greater potential performance offsets the additional cost.  But ESG doesn’t have a particularly strong track record, especially if you consider its forebears.      

Before ESG became the most recent popular marketing name for investment strategies which prioritized an investor’s feelings over cost and performance, there were “socially responsible” funds which restricted investment in oil companies, or cosmetic companies that tested on animals, etc.  Before that, back in the 1990s, a fund fact sheet might have enticed socially-minded investors by explaining that the fund’s objective was to limit investment in “sin stocks” like tobacco or gambling. 

The trend of the 1990s largely died out as a fad due to underperformance.  It was reinvented in the wake of global warming hysteria in the 2000s, but yet again, these funds were often terrible sellers due to lower performance.  And that is because these funds will typically not, except in some very specific circumstances, outperform funds that are not constrained by ESG considerations.

As Allison Schrager at Bloomberg reminds us, a hedge funder named Cliff Asness “caused a small stir in the ESG community” by stating the obvious back in 2017.  “ESG funds will typically return less than funds that are free to invest anywhere,” she summarizes.  Schrager goes on:

He explained that constrained optimization will result in lower returns than unconstrained.  It makes intuitive sense: if you need to turn down a good investment because it isn’t ESG compliant, that means you’ll earn less money than someone who is free to invest in it.  The more constraints you put on yourself, the less you can expect to earn.  Asness was baffled that ESG was being sold as a good investment.   

And that’s just it.  Logic alone suggests that ESG is extremely unlikely to be a “good investment” in the long term, for the same reason an NBA team which arbitrarily requires the composition of its players’ skin color to mirror national demographics as a whole would most certainly not be a successful team in the long term.  The team would undoubtedly pass over the best talent available in order to meet a “diversity” goal that’s entirely different than what the team’s goal should be, which is winning games and championships. 

ESG has had the veneer of a good investment these past years, though, and they’ve grown in popularity.  The reason for the latter is because “virtue investing,” much like virtue signaling, has been cheap in recent years.  Virtue signaling by putting a BLM and a “Hate Doesn’t Live Here” sign on your lawn in your gated community costs little and feels great in a society where progressive ideas dominate the governmental, academic, and corporate landscape.  Similarly, when markets are broadly strong and inflation is low, the cost of virtue investing by paying more for a less efficient investment is small.  But as inflation rages and markets are turbulent, it should surprise no one that we may now be witnessing, as Schrager puts it, “the end of the virtue economy bubble.”

The “why” of the bubble shouldn’t be too hard to see.  Where do ESG funds invest their money, after all?  Certainly, they like the “green energy” companies which have enjoyed massive taxpayer-funded government stimulus and an orchestrated effort by the Biden administration to destroy their competition in the marketplace.  Oh, and then there’s Big Tech.  There are few places to find more of the kind of diversity quotas that ESG funds are looking for -- you know, skin color, sexual preference, gender identity, etc. -- than the tech industry.  It’s no wonder that ESG funds tend to be tech-heavy, and it’s equally no wonder that tech companies absolutely love ESG.

But when the taxpayer stimulus dries up, when everyday Americans’ energy costs go through the roof, and when the need to control unbridled inflation makes it more expensive for companies to borrow money while creating a market that makes it riskier to invest their own, it becomes apparent that ESG investments are of less value to stockholders than they are of value to woke ideological “stakeholders.”     

The “virtue economy” bubble is indeed bursting, and we are watching it in real time.  The CFO of the state of Florida, Jimmy Patronis, just weeks ago, fired BlackRock for its woke shenanigans, pulling $2 billion from the firm’s management.  He tells BlackRock:

As major banking institutions and economists predict a recession in the coming year, and as the Fed increases interest rates to combat the inflation crisis, I need partners in the financial services industry who are as committed to the bottom line as we are -- and I don’t trust BlackRock’s ability to deliver…

Whether stakeholder capitalism, or ESG standards, are being pushed by BlackRock for ideological reasons, or to develop social credit ratings, the effect is to avoid dealing with the messiness of democracy.  If Larry [Fink, CEO of BlackRock], or his friends on Wall Street, want to change the world – run for office.  Start a non-profit.  Donate to the causes you care about. 

Using our cash, however, to fund BlackRock’s social-engineering project isn’t something Florida ever signed up for.  It’s got nothing to do with maximizing returns and is the opposite of what an asset manager is paid to do.  Florida’s Treasury Division is divesting from BlackRock because they have openly stated they’ve got other goals than producing returns.

In other words, Jimmy Patronis and Florida (like you, in regard to your your 401(k) manager), want an actual fiduciary when it comes to their investments, and not an asset manager which prioritizes a government sponsored ideological crusade over producing the best returns possible for its investors.

Image: Pixabay / Pixabay License

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