Should ESG investing be criminalized?

Um. Taken literally – how else should legislation be passed? — this provision prohibits New Hampshire officials from investing the state’s money in portfolio managers who pay “any regard” to “management criteria.”

If investment professionals are concerned that a company has appointed relatives of CEOs to its board of directors or failed a cybersecurity audit, they cannot act on those matters without endangering the New Hampshire official who appointed them. chosen.

(It’s worse than that. The bill states that those investing on behalf of the state of New Hampshire can have “no regard” for management issues. Under the wording of the proposal, portfolio managers may not even think about such topics.)

Additional problems

Environmental and social regulations are not much better. It is assumed that the bill’s authors seek to prevent stock picking because their organizations are considered by portfolio managers to be “good corporate citizens.” But again, the bill’s language is too broad. Thus, whether a company could pay large pollution fines or face an impending labor strike would be out of bounds.

If there are any lingering doubts about the soundness of this proposal, the severity of the punishment should erase them. The bill states: “the crime is punishable by imprisonment for not less than one year and not more than 20 years”. Is now. The maximum sentence in New Hampshire for kidnapping, first degree assault, or sex trafficking is 15 years.

Obviously, none of these crimes are as depraved as allowing a portfolio manager to invest through ESG principles.

The main problem

Flaws aside, the bill raises a legitimate question: What is the outlook for ESG investing?

Those who sponsored the legislation suggest that the ESG mindset is doubly harmful because it reduces portfolio returns while increasing risk. Public officials, they argue, have a fiduciary duty to “maximize financial gains and minimize risk.” But state representatives are generalists, not subject matter experts, and their views in this case are decidedly partisan.

Let’s look instead at what unbiased researchers believe. They generally ignore the prevailing discussions. The general debate about ESG investing consists of proponents arguing that considering ESG factors avoids future problems, while opponents argue that addressing such concerns harms profitability. ESG is “all about awakened diversity,” said Home Depot ( HD ) co-founder Bernie Marcus. “Things that don’t reach the bottom”.

This is an old rehashed argument. Long before ESG existed, business school professors debated whether American firms paid too much attention to current profitability, too little, or just the right amount. Running a corporation inevitably involves trade-offs: how much to spend today to avoid tomorrow’s problems? For this question, the accepted answer is “it depends”. The dispute cannot be resolved in theory.

Potential Objection 1: Lower Risk = Lower Return

However, there are more substantial criticisms of ESG investing. One involves taking the claims of ESG proponents at face value. If assessing ESG issues is just another form of risk control, then funds that invest with ESG principles in mind will on average hold fewer risky stocks. But the answer comes because risk and return are related, with higher risks generating higher expected returns, ESG funds will make less money than their competitors.

Fair enough. However, this argument undermines New Hampshire’s proposal. There is nothing wrong with investing in securities that have a lower expected return because they carry less risk. If there were, only portfolio managers who invested in highly speculative securities would be eligible. For example, it would be illegal to invest in US blue-chip stocks because emerging market stocks have higher risks and therefore higher expected returns.

It should also be noted that the connection between such theory and practice is extremely tenuous. Although the rule is true if all things were equal, all things are rarely equal. Therefore, its explanatory power is weak. For example, US blue-chip stocks have displaced emerging market stocks in recent decades.

Potential objection 2: Higher popularity = lower returns

Another objection to ESG investing is that because so many investors are attracted to companies with high ESG scores, the prices of such securities are inflated. Due to their popularity, their past results have been strong, but their future results will be weaker. Pay more, get less.

This argument is also rational. It would certainly be applicable if the facts supported it. However, this is far from clear. For example, when Morningstar conducted an in-depth study of global stocks covering the 11 years from 2009 to 2019, it found that stocks with the best ESG scores were cheaper than their peers. On average, they had both higher dividends and lower price/earnings ratios.

Also, while logically sound, the popularity asset pricing model is difficult to implement. After all, before a stock lags because it has become too expensive, it outperforms while becoming overvalued. Is ESG in the first stage or the second? The question is unanswered.

Moreover, if the answer is that ESG stocks still occupy the first stage, then their expected returns are relatively high, not low.

Potential objection 3: Actual performance

Because so many countries (including a subsidiary of Morningstar…) publish ESG risk scores, and because investment performance can be measured over many periods, for many countries people can come to whatever conclusion they want.

And because ESG investing is both a highly politicized topic and one that can potentially generate significant profits for its proponents, that’s actually what happened. Both sides have issued reports that seem to confirm their beliefs.

So I will leave these studies aside. No doubt many of these have been evaluated, but since they yield conflicting results, I conducted my own investigation instead. I sifted through all large-mix US equity funds with a five-year history (longer would be preferable, but few ESG funds existed a decade ago), sorting them into four camps: 1) non-ESG index funds; 2) index ESG funds; 3) non-ESG active funds; and 4) active ESG funds.

I had hoped to present four results, but was unable to do so. The non-ESG index funds contained several “low volatility” funds that messed with the conventional strategy, thereby reducing the returns of this group. Instead, I chose to showcase the two largest index funds in the industry, the Vanguard Total Stock Market ETF (VTI) and the Vanguard S&P 500 (VOO). Since Vanguard also offers an indexed ESG investment, the Vanguard ESG US Stock ETF (ESGV), I’ve included that as well.

(I omitted measures of risk because, regardless of potential objection 1, the standard deviations of returns for all groups were similar.)

The result is a Rorschach investment test. If you see a win for ESG funds or their competitors, that’s what you want to see. One side won the indexing battle, the other won the active battle, and in neither case were the results significant. No conclusions can be drawn from such modest differences.

Now, if you want to revise the New Hampshire bill to shut down recruiters who hire active portfolio managers…