Why Is ESG Investing So Controversial?

Following up on my colleague Sarah Hargreaves’s post on ESG investing, I thought I would comment on some discussions and questions I have had on the topic. For what is at bottom a simple attempt to make better investment decisions, it has become a surprisingly controversial topic. So, let’s dig in a bit into what is actually happening when we talk about ESG investing. 

ESG Standards

First, let’s start with the ESG standards themselves, which stand for environmental, social, and governance. You can certainly interpret these as being politically oriented, but why? Taking them out of order: 

• Good corporate governance means being responsive to shareholders, which, after all, is what any investor should want.
• Social means taking account of the impacts a business has on society, which certainly have an effect on the appeal of that business to customers (as we have found repeatedly in recent years) and, therefore, on the business and financial results.
• Environmental also has a perception impact, as well as an impact on whether the business can be run sustainably over time. Slash-and-burn agriculture may be more profitable in the short run, for example, as long as there is always more jungle. But properly managing farmland is more sustainable—and more profitable over time. 

Properly speaking, ESG doesn’t replace the financial metrics but gives a more complete picture of them. There is nothing here that implicitly should be a problem, as they are simply analytical tools. 

Unpacking the Controversy

Of course, it is how those tools are used that matters. Here, the basic worry seems to be that asset managers are using their financial clout to vote the shares entrusted to them by investors to make companies not do the maximally profitable thing but, instead, run their businesses to change the world in certain specified ways. There are two main concerns I hear. First, investors are suffering as companies are being forced by institutional asset managers to run their companies in a sub-optimal way. Second, those institutional asset managers are forcing companies to drive outcomes that the actual investors don’t support. 

Let’s take these in order. First, a bit of self-interest here. Asset managers typically get paid based on a percentage of the asset value they manage, so they have a significant incentive to get the highest returns they can. Second, those same asset managers are, as fiduciaries, subject to legal requirements to do the same. For the asset management industry as a whole, there are both carrots and sticks in play to seek out the best possible financial returns. 

To believe that asset managers are not trying to maximize returns is to conclude that they are willing to hurt their own paychecks and take meaningful legal risks in order to change the world. The evidence is against both of those for the vast majority of the industry. Think about it. With billions of dollars on the table, if there was any real evidence of asset manager slanting, don’t you think lawsuits would already be in play? 

Now, to get to the second point, that’s not to say some fund managers are not trying to change the world: they are. But those funds are typically very explicitly marketed as such to investors looking for that kind of impact. Because those funds are looking for those investors, they have a clear incentive to make their orientation obvious—and their self-interest and fiduciary requirements point very clearly in that direction. 

For the remainder of the industry, though, ESG may be a marketing strategy or simply incorporated into their standard investment practice, which as noted above makes sense, for purely financial reasons. But their decision processes and incentives are as return-maximizing and fiduciary as they have ever been. For those investors, they might act at the margins when their ESG standards have financial implications, but the motivation would be to improve the financial results. From my perch in the industry, there simply isn’t a massive conspiracy on the part of the investing world to rob investors to pay for the woke agenda. Those products are out there and, for those who want them, are easily findable. 

Responsibilities of the Financial Advisor

That brings us to the responsibilities of the financial advisor. We need to know what we are investing in, to know what our clients’ objectives are, and to properly match the two. In Commonwealth’s case, we have resources dedicated to ESG investing for those who want that. Our non-ESG portfolios—most of them—do pay attention to ESG standards, as they inform the financial results, but are focused on investment performance. If an ESG fund does show up in the non-ESG portfolios, it is for financial reasons. In short, we differentiate between the two, and we give our advisors the tools to do the same. 

The Bottom Line

ESG investing in itself is value neutral, as a set of analytical techniques designed to further inform the financial analysis and investment decision. Those tools can, of course, then be used to implement value-based judgments and to drive desired impacts from that investment, but this is similar to other value-based investment processes. Investment managers use, or should use, all of the tools available to improve their results, but they have clear incentives (both positive and negative) to disclose how they are applying them and what the results are. 

Is this something to be aware of? Yes, for reasons both positive and negative. Is it something to worry about? No. 

Keep calm and carry on.