Is ESG a Viable Performance-based Strategy, or is it Marketing Noise? – DataDrivenInvestor

The big ESG Question…

“Demand for ESG [environmental, social, and governance] is going to transform all investing.”


Question: is ESG a viable investment strategy, or is it just marketing hype? The answer is complicated.

ESG is one of the hottest themes in investing today. To be very clear, I believe that ESG investing is here to stay — and I believe that is a good thing. I am a capitalism true-believer, but I also believe we can build and invest in a manner consistent with our values. For me, it is not a binary either/or. We can successfully do both. With that being said, has the last decade+ of ESG investing proven itself as a valuable investment strategy? Well, that is a question that is a bit more difficult to answer.

Two decades ago, many institutional investors rolled their eyes when they heard the term ESG. Although it was called ‘Impact’ investing back then. To be fair, they had good reason to roll their eyes. Up to that point ESG/Impact investing had a rather poor investment return track record. It was generally viewed as philanthropy by a different name. Not that there is anything wrong with philanthropy. Philanthropy is great. It is just that institutional investors believed that investors should separate capital earmarked for philanthropy and capital earmarked for ‘return’ into different categories. ESG/Impact investing tried to blur those lines, and professional investors did not always appreciate it.

Fast forward to today. If ESG/Impact investing had a bad reputation, you would never know it from the significant size and power that it has grown into. In today’s investing world, if your fund or company is not specifically focused on ESG, you are doing whatever you can to highlight its ESG attributes. Institutional investment groups such as pension funds, foundations, and endowments are demanding ESG-related investment options — and the market is responding in kind. An article in Institutional Investor recently commented on this growth. From the article: ”In late 2018, while seated on the dais of The New York Times DealBook Conference, BlackRock CEO Larry Fink declared that ‘demand for ESG [environmental, social, and governance] is going to transform all investing.’ At the time, Fink’s assertion seemed bold. Today it looks prescient. Escalating social and environmental challenges and claims that ESG investing can deliver alpha (outsize market returns) and a more sustainable planet have prompted investors to divert more than $3 billion per day to ESG investment products. According to Bloomberg, ESG investment now represents approximately one third of all professionally managed assets.”

Just take a second to let that sink in. To reiterate, the report states that investors are diverting more than $3 billion PER DAY into the strategy. Yes, I think it is fair to say that it is transforming investing.

It’s All the Same, Only the Names are Changed

Many investors probably would be surprised to discover that ‘ESG investing’ is not a new development. The philosophy behind the strategy has been around for almost half a century. The names have changed, but the idea is the same. As detailed in the article, “First branded socially responsible investing (SRI), ESG strategies date back 50 years. In the 1970s, investors, including some faith-based institutions, sought to invest in a way that was consistent with their values, and funds were created to fill this demand. These funds exclude companies whose activities investors deemed immoral — such as support for apartheid in South Africa, the sale of tobacco products, or the production of nuclear weapons.” From decade to decade, the strategy ‘branding’ has changed. As pointed out above, it started out as SRI, was often referred to as ‘anti Sin-stocks’, spent a good deal of time being called Impact, and now is widely accepted as ESG.

Marketing Bonanza

While it has been around for decades, investment experts continue to hotly debate its promise to deliver higher investment returns while ‘doing good.’ The big question remains. Has it worked?

Well, the jury is still out on the performance side of ESG. But more on that in a second. First, let’s take a look at the marketing side of the equation. From a marketer’s perspective, ESG is a HUGE winner. Adding ESG attributes (or at least the name) to investment funds has been one of the most beneficial innovations in investment marketing over the last two decades. As pointed out in the article, “The opportunity to generate alpha with lower beta and planetary impact has proven to be an extremely effective way to market funds. In the past two years, inflows to ESG funds have been almost twice those of the rest of the stock universe combined. To get in on the boom, asset managers have increased the number of ESG funds by five times over the past decade, according to Morningstar, and aggressively repurpose and rebrand conventional products into sustainable offerings.”

Given the magnitude of the capital inflows into the space, it is hard to argue that ESG has been widely successful — from a marketing standpoint.

It Talks the Talk, But Does it Walk the Walk?

Now, let’s get to the thorny issue. Has ESG delivered on its promise to generate higher alpha, lower beta, in a more socially-conscious way? Well, come to find out, that is a complicated question to answer. The truth is that there are indeed some sectors in which is has delivered, and some that it has not.

One interesting industry in particular is the electric vehicle ecosystem. This industry sector has received a ton of attention and capital over the last decade. Returns for many growth-stage companies have been stellar. However, some investment experts argue that many ESG funds can simply attribute performance success to heightened capital inflows generated from marketing hype. In the article they argue that, “the flow of investment capital itself could cause higher returns. Over the past three years, $20 trillion has flowed to ESG assets. These flows increase demand for highly rated ESG companies, thereby raising asset prices. In July, Karen Karniol-Tambour, co-chief investment officer for sustainability at hedge fund Bridgewater Associates, said, “We suspect that large ESG flows are still ahead of us. Investors shifting to more focused portfolios of sustainable companies would increase relative stock prices.”

Well, this is how markets work — supply and demand. If the market is demanding greater access to ESG-related funds and companies, then capital will flow into the space. As capital flows into the space, asset prices tend to rise. However, this dynamic is only sustainable (pun-intended) for as long as that capital continues to flow. From the article, “There is little reason to doubt that money flowing into investments can increase prices for a time, thereby allowing early investors to accrue higher returns. Sometimes the rising prices can in turn give a veneer of authenticity to the investment strategy. Stock bubbles are formed in this way, and one could easily see this happening with ESG investing.”

A Term that Has Been Stretched Too Far

Unfortunately, I believe that the challenge in evaluating ESG-specific investments is that the definition of ESG has been redefined and ‘stretched’ over time. I think that overall it is a good thing for companies to intentionally build ESG-related goals, intentions, and philosophy into their DNA. However, if every company and fund is now doing so, it could render the term ESG as a specific strategy mostly irrelevant.

The larger question becomes, if we can’t agree on the definition, how could we ever agree on the performance metrics? From the article, “ESG investing is not precisely defined. As a result, studies and funds deliver mixed results depending on how each defines ESG. Funds focused on diversity, resource scarcity, climate tech, and women’s empowerment could all be classified as ESG investments. So too both active and passive funds.” With this large of a scope, it is next to impossible to answer the question of how well ESG-focused investments have done. If everyone is ESG, then no one is solely ESG. If that is the case, parsing investment performance relative to the general market is nearly impossible.

In the End, Capital Flowing to Positive Goals is Good — Just Choose Carefully

As I mentioned at the opening, I believe that ESG investing is here to stay — and I believe that is a good thing. However, I also believe that investors need to step into situations with their eyes wide open. Just putting the label ESG on an investment does not automatically give it magic powers to generate outsized returns.

Institutional demand for ESG-related investments is high right now. Particularly with large pools of capital such as endowments, foundations, and sovereign wealth funds. As I mentioned earlier, the investment world is responding to that demand with ever-larger offerings of ESG-related investments. Without question, a level of hype has seeped into the space.

Investors just need to be aware.

© Copyright 2022. Marc Patterson/Bennu Partners. All Rights Reserved

“ESG and Alpha: Sales or Substance?” by Andrew A. King and Kenneth P. Pucker, Institutional, 2.25.2022

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