- Individuals and large institutions alike are allocating more of their dollars to investment strategies
that meet some level of environmental, social
and governance criteria. This is commonly referred to
as responsible, sustainable or green investing. I'll use sustainable to
describe it in this video. According to the 2018 global
sustainable investment review, as of the start of 2018, more than 25% of US domiciled
assets under management were invested in sustainable strategies. In Canada, it is just
over 50% at 2.1 trillion in Canadian dollar terms, that's up 42% since 2016 BlackRock, one of the world's
largest asset managers recently committed to
making sustainability a key part of their investment process. This growth in sustainable investing is good news to the extent that sustainable investing leads to positive social impact, but it also has some
important implications for expected investment outcomes. I'm Ben Felix Portfolio
Manager at PWL capital. In this episode of common sense investing, I'm going to tell you how you
can align your investments with your views and values. But it's probably going to cost you. (upbeat music) The two most common types of sustainable investment strategies are negative screening
and ESG integration. Negative screening eliminates certain sectors, companies or practices from a portfolio. ESG integration is more of a re-weighting. Instead of completely
eliminating industries, an integration strategy will underweight companies
with lower ESG scores and increase the weight of companies with higher ESG scores. There are index funds that
employ both of these strategies often in combination with each other. Having a sustainable portfolio sounds like a really good idea and it might feel even
better than it sounds. However, I think that you need to consider two equally important factors in deciding to implement a
sustainable investment strategy. The first factor is the impact
on your expected returns. And the second is the extent
to which the investment actually reflects your views and values. These two considerations
need to be assessed jointly. If a sustainable portfolio has slightly lower expected returns, but is a perfect reflection
of your views and values, you may be willing to
accept the trade off. But accepting the lower expected returns of a sustainable portfolio that does not reflect your
specific set of use and values, might not be a trade-off that most investors should consider. Let's start with the impact of socially responsible
investing on unexpected returns. The effect of ESG scores on stock returns was
examined in the 2019 paper by Rocco Ciciretti, Ambrogio
Dalo and Lehmertjan Dam. They controlled for common risk factors and looked at a global sample of 5,972 firms for the
period 2004 through 2018. They found that companies
with higher ESG scores tended to deliver lower average returns than companies with lower ESG scores. They found a statistically
significant negative premium for the ESG characteristic in a traditional Fama French
five factor regression a six factor regression,
including momentum and a seven factor regression,
including an ESG risk factor. They found that a one
standard deviation decrease in the ESG score is associated
with a 0.13% increase in monthly expected returns. Put simply, controlling for exposure to known drivers of returns companies with higher ESG scores tend to do worse than companies with lower ESG scores. The authors considered
two possible explanations for this observation, both grounded in economic theory ESG characteristics reflect
investor preferences or ESG characteristics are captured by some
underlying ESG risk factor. Based on the previously
mentioned factor regressions, they found it much more likely that it is an investor preference that drives a negative ESG premium. Investors may be willing to accept lower expected returns simply because they do not want to invest in certain types of firms. This is not a risk premium but an effective investor tastes. That word tastes is important. In their 2007 paper, disagreements, tastes and
asset prices, Eugene Fama, and Ken French explained that investors may hold an asset partially as a consumption good, regardless of its expected return profile. If they have a taste for that asset. If enough wealth is controlled by investors with specific tastes such as the case of sustainable investors, the effect on prices could be meaningful. Another way to think about this is that investors with a taste
for sustainable investments require higher expected returns to be convinced to invest
in an unsustainable company. This drives up the expected returns of unsustainable companies. They're also willing to accept lower expected returns to invest in sustainable companies. This drives down the expected return of sustainable companies. In a 2019 study, Olivia David Zerbib, developed an asset pricing model including premiums for ESG
exclusion and investor tastes. The premiums for exclusion are related to the
increased risk of stocks that are neglected by
sustainable investors. The premium for investor
tastes is related to the cost of externalities that sustainable investors internalize to maximize their welfare instead of the market
value of their investments. Using this model, Zerbib analyze US stock
data between 2000 and 2018. He found an exclusion
effect of 2.5% per year and a taste effect of 1.5% per year. These effects show the
approximate magnitude of under performance
driven by respectively a negative screen and an integrated approach
to a sustainable portfolio over the time period examined. As ESG preferences grows stronger, the expectation is that
these pricing effects will become more pronounced in a 2019 paper, Lubos Pastor, Robert
Stambaugh and Lucian Taylor constructed a theoretical model
to examine the implications of ESG investing on expected returns. They, again, found that firms with higher ESG scores
have lower expected returns and those expected returns get lower when risk aversion is low
and ESG sensitivity is high. They also found that the size
of the ESG investment industry increases as the dispersion
of ESG preferences increases. I know that was a lot to take in. So think about it this way. If everyone has the same ESG preferences, the same willingness to
invest in bad companies if the expected return is high enough and to invest in good companies, despite a low expected return then everyone will hold the
market portfolio and be happy. There will be no ESG investing industry if everyone has the same preferences. If there are two groups, one group with no ESG preferences and one group with strong ESG preferences, then there is an ESG investing industry. As the dispersion in
ESG preferences grows, the ESG investing industry gets bigger and expected returns for
sustainable portfolios get lower. Pastor, Stambaugh and Taylor, also found that sustainable investing leads to positive social impact by encouraging sustainable firms to invest more while discouraging unsustainable firms from investing due to the
effects of investor preferences on their cost of capital. Let's recap. Yes, you can encourage change in the world by investing in companies
that meet ESG criteria, but as long as there is
dispersion in ESG preferences, you are doing so at the expense
of lower expected returns. This joint effect must be true. If sustainable investing works the way that it is supposed to, by putting pressure on
unsustainable companies, then the firms excluded from sustainable portfolios must have higher expected returns, meaning sustainable investors must have lower expected returns than the preference free market. I think that we have established that investors should expect
lower risk adjusted returns from a sustainable portfolio. A portfolio with a negative screen that entirely eliminates industries will tend to be more impactful to expect the returns than a portfolio with
an integration approach that re-weights companies based on their ESG score. In either case, lower expected returns are a consideration for investors with above
average ESG preferences reflected in their portfolio. Lower expected returns
are not the only cost that's sustainable investors endure, by definition a sustainable portfolio, must be less diversified than the market. A reduction in diversification reduces the reliability
of the investment outcome. If companies with high ESG scores had higher expected returns, the increased concentration
and decreased reliability could be viewed as a reasonable trade-off. But companies with higher ESG scores have lower expected returns. We are getting a less reliable portfolio with a lower expected return, not an optimal trade-off. We also have to consider fees, a globally diversified portfolio
of Canadian Listed iShares ESG ETFs comes with a cost
of around 0.28% per year. While a similar iShare the ETF portfolio with no ESG consideration
would cost 0.12% per year, lower expected returns,
less diversification and higher fees are the costs
of a sustainable portfolio. These costs exist on a continuum. The more sustainable that we want to get the higher the costs tend to get. If we start on one end of the spectrum we might have XIC, the iShares core S&P/TSX
capped composite index ETF. No ESG filter, market cap weighted, 235 holdings and a 0.06% expense ratio. It will almost certainly deliver the market's return after costs. XESG, the iShares ESG
MSCI Canada Index ETF favors companies with high ESG scores. It has 129 holdings and
an expense ratio of 0.22%. MSCI has designed the index to have an expected 1% tracking error. So you expect to get
the market return plus or minus some random error. If we wanted more sustainability, we would need to increase
the tracking error budget and expect higher fees. For example, the Desjardins RI Canada low CO2 index ETF has 63 holdings, more exclusions and stricter ESG criteria. It has an expense ratio of 0.29%. As we move along this
continuum of trade-offs, the higher costs might be worthwhile if the result is a portfolio
that increasingly aligns with your views and values, but this is one of the biggest problems that sustainable investors face. There is a huge difference
between investing in a product with ESG green or sustainable in its name and investing in a way that
aligns with your values. Even the rating agencies, that determined the ESG scores don't agree on the definitions. This was explored in a 2019 paper by Florian Berg, Julian
Kolbel and Roberto Rigobon. They looked at ratings from five prominent ESG rating agencies and found that their ESG ratings
have an average correlation of 0.61 with a range
between 0.42 and 0.73. The disagreement is driven nearly equally by differences in ESG definitions and differences in how those
definitions are measured. For context, credit ratings from Moody's and Standard and
Poor's are correlated at 0.99. We can look at the MSCI Canada
IMI extended ESG focus index as an example. This index takes an integration approach combined with total exclusions, for tobacco, controversial weapons, producers of, or ties
with civilian firearms and businesses involved
in severe controversies. All good things to avoid for
a socially conscious investor. Now here's the issue. One of its largest holdings is Suncor, a Canadian energy company specializing in synthetic crude
production from oil sands. More than 16% of the index is
made up of energy companies. A different index provider FTSE creates ESG indexes that exclude oil, gas and coal companies. They don't exclude downstream companies like pipelines but it's still
a step in the right direction. This difference in ESG index construction it should be a surprise from the Berg, Kolbel and Rigobon paper, we can see that energy specifically is a major point of disagreement
across ESG rating agencies with an average rating
correlation of only 0.29 at the energy category level. The inclusion or exclusion
of oil and gas companies in an ESG index is only one
example of a larger problem. Name your social or
environmental issue of choice and different index providers are likely to treat it differently. Similarly, if an index
provider treats one issue the way that you would hope they might not align with
your views on other issues. This is a big problem
from two perspectives. Investors might end up
enduring the higher costs of a sustainable portfolio while owning companies that
conflict with their values and companies might be
confused about which actions they need to take to improve
their ESG performance. Approaching the sustainable
investing problem successfully ends up
requiring precise management of the trade-offs between
implicit and explicit costs and your specific set of views and values. The perfect portfolio from the
perspective of using values couldn't end up being
too under diversified too expensive or otherwise impractical. On the other hand, the simplest cheapest and
most diversified portfolio is likely to conflict on some level with the views and values of most sustainable minded investors. Step one for a sustainable investor is understanding that as long as there is
dispersion in ESG preferences sustainable portfolios have
lower risk adjusted returns. Step two is making a decision about the acceptable level
of portfolio trade-offs in meeting the ESG preferences that you have where stronger ESG preferences will generally mean less diversification lower expected returns and higher costs. Step three is probably
the most important step. It is verifying that the
products that you have selected truly reflect the views
and values that have motivated you to be a
sustainable investor. Thanks for watching. My name is Ben Felix of PWL capital and this is Common Sense Investing. If you enjoyed this video, please share it with someone who you think could benefit from the information. Don't forget, if you have run out of
Common Sense Investing videos to watch, you can tune into weekly episodes of the rational reminder podcast wherever you get your podcasts. (upbeat music)
When maximizing profits (in a risk averse way) no longer is your number one goal you're bound to get lower returns.
Funny - a friend was just asking me about sustainable/ethical investing, and I had to tell her (in a nutshell) that we live in a flawed capitalist world and that I don't think there's any avoiding it. Also whenever I look at the contents of these funds I see plenty of 'evil' companies in the mix. Best I can do: invest, but also donate to charities.
Most of what I'm about to say is either explained in this video or sourced in the description. The rest is sourced directly via links in the text. Please watch the video first, as it is necessary context for this post.
ESG investing yields lower returns compared to non-ESG funds in the same sectors and exposed to the same factors (like small cap, growth, etc.) This is theoretically justified and historically evident. The reasons have nuance but let me put it simply: When a large (but not unanimous) portion of the market is receiving a consumptive good benefit (i.e., you are getting a social, personal, or psychological reward) for investing in a certain kind of asset, or excluding a certain kind of asset, then the price of that asset will be higher than a comparable asset that carries no such benefit. This means you overpay and have lower expected future returns. The inverse is also true: If you pay a non-financial cost for investing in a certain asset, you will underbuy that asset, and thus it will be cheaper. Think about the social, psychological, or reputational costs you might incur for telling your friends, neighbors, teachers, or political allies that you invest in private prison companies. When this dynamic is at play for some, but not all of the market, the portion of the market that is doing the "ESG investing" is by definition expecting lower future returns. This fact is unavoidable from an economic lens, and has been confirmed empirically.
Felix in the video also goes into more depth about other adjacent reasons that this must hold. One is the fact that there is, of course, a level of return differential between ESG and non-ESG investing that would cause even the most fervent ESG investors to stop ESG investing, and this fact alone means that non-ESG investing has a higher expected return. Also, the MORE people invest in ESG, the LOWER the expected return for someone buying in or holding those assets becomes. Some people are tempted to think to themselves, "I'll buy ESG funds in the hopes that in the future, more people than ever buy ESG funds" but this is an explicit greater-fool theory of investing that -never works for the majority who participate in it, by definition.- With 25% of US stock money being in ESG funds (and 50% of Canadian $!), who is really the fool? When the top suggested ETFs by the entire internet tend to be explicit ESG plays like clean energy ETFs and ARK funds, where are you on the fool continuum for buying or holding those assets? Greater-fool speculative market timing doesn't work, but what you can be sure of, in this circumstance, is that you are buying overpriced equities that will depress future returns when things return to their fundamentals...this is a logically necessary, unavoidable implication if fund flows are determining price increases!
One might point out, "but look how good X industry has done! Clean energy has outperformed fossil fuels!" This is a tempting response, but the researchers aren't stupid. Certain factors are always outperforming other factors, and in this case, growth companies and tech companies have been on an incredible run. The authors -already control- for sector, size, momentum, value/growth, investment, profitability, and so on. When you control for all of that, then look specifically at the differences between two batches of companies that are equivalent in every financially relevant way, but one has ESG designations and one doesn't, the ESG underperforms. ESG funds are indeed in sectors and factors that have outperformed, but they UNDERPERFORMED relative to non-ESG holdings in those same sectors and factors. ESG-ness itself turns out to be a net harm to returns both in theory and in practice.
The other aspects of the costs of ESG investing are even simpler and surely unlikely to be doubted, but I'll quickly say them again. The fees of ESG funds are higher than the fees of other diversified market-weight index funds and targeted factor funds. The turnover is higher as well. Also, the difference in diversification is obvious...a subset of the market is never as diversified as the entire market. To remind people of the benefit of diversification: When you lower your diversification substantially, you raise your risk, raise your volatility, and increase uncertainty about future returns...and, crucially, lowering diversification does not increase your expected future returns. William F. Sharpe won a Nobel Prize in part for proving that you do not get paid for taking more risk when the risk can be diversified away. So not only does lowering diversification not increase future returns, in the case of ESG, it reduces your future returns as well.
Another aspect of ESG investing not covered in the video but more than worth mentioning, is that ESG stocks tend to be in the category of stocks that have the -lowest historical and expected returns of the entire market-. The authors of the study control this away in order to isolate ESG-ness, but let me also share the factor information of the companies you are buying into. These companies tend to be growth stocks, almost all of them are unprofitable, and they are biased toward being small, and they exhibit high positive skewness (they have a higher-than-normal chance to have massive returns). Small cap, unprofitable growth stocks are the Black Hole of Investing. From the Lottery Ticket Effect where investors consistently overpay for stocks that have a higher chance of massive short term returns, leading to lower total average returns, to the fact that they have liquidity problems and are difficult to short, leading to prices being set systematically higher than they should because the market is unable to knock them down, ESG investing biases toward market segments that are are bad, bad, bad, and bad. Not to mention, "technological revolution" investing tends to be a loser's game, with prices being very prone to bubble behavior and consistent overpricing and lower returns relative to declining industries. I'll say it again, recent massive overperformance of ESG industries/factors is not a counterargument here...it is just further reason to believe that you are not getting a deal or buying/holding underpriced stocks.
ESG investing is the -opposite- of a free lunch. It harms your portfolio in just about every way that a portfolio can be harmed. If more people interested in ESG investing knew this, I suspect they may think twice about whether they are willing to sacrifice so much for so little, if any positive impact on the world. Consider keeping your portfolio invested rationally, with low cost total market indexes, potentially biased toward higher expected return assets in the market, like small cap value (AVUV, SLYV, AVDV) or emerging market stocks (VWO,AVEM), and then simply donating the money you can afford to the objectively most cost effective charities in the world, such as those identified by https://www.givewell.org/ and https://www.thelifeyoucansave.org/ . Perhaps taking the profits from the "sin stocks" and reinvesting them effectively to help the world could preserve both your portfolio and the sense of purpose that many get from ESG.
That's a solid video.
Finance has had religiously motivated investing for a long time with people of various religions wanting portfolios that filter out companies that make products they are averse to on moral grounds. ESG is along the same lines but the "religion" in this case is leftist/liberal politics. Unfortunately, there is large dispersion on what liberals believe and value and it's not at all clear which companies are better or worse at those things, so there isn't a great definition of what kind of company qualifies as "sustainable."
Anyone who thinks about it for 2 seconds and isn't into self-deception will know that restricting your portfolio will likely have a negative effect on your risk/return profile. However, I don't think many investors are aware of the great differences between definitions of ESG and how much they may differ from what the investor actually values.
What you're missing is the point that capitalism right now is inherently unsustainable, and profits are maximized by exploiting human, social, and natural capital. As customers, governments, and employees recognize this fact, corporations are competing to get ahead of the expected change in regulations / preferences. Those who are ahead are seeing higher profits.
You make the statement that "ESG investing yields lower returns compared to non-ESG funds in the same sectors and exposed to the same factors (like small cap, growth, etc.) This is theoretically justified and historically evident". However, ESG funds have been outperforming their non-ESG peers: https://www.morningstar.com/articles/1017056/sustainable-equity-funds-outperform-traditional-peers-in-2020
I understand the theoretical argument that Ben is making here about lower *expected* returns, but historic performance is telling a different story.
If you're exploring the topic and open to a different perspective, here's my interview with Ben for his podcast Rational Reminder: https://rationalreminder.ca/podcast/63
Good example of Power vs. force
The Market doesn't really care about Do-Gooderism & SJWs.
It is not emotionally invested in narratives, it is a weighing station.