I help families/small businesses discover wealth-building strategies.
With President Biden's veto of the Congress's bipartisan joint resolution, ESG has been one of the hottest news stories in the financial world. Beyond the politics of it, proponents and opponents of the ESG push have their own reasons for staking out their positions. Would it surprise you to learn that self-interest plays a role?
At its most basic core, ESG is merely an extension of placing portfolio restrictions based on subjective, rather than accounting, factors.
"Explained in simplest terms, 'ESG' stands for environmental, social and governance which is an investing strategy that takes into account a business's environmental and social risks as part of a broader financial analysis," says Rob Reilly, finance faculty at the Providence College School of Business and investment consultant at North Atlantic Investment Partners in Boston.
How you use ESG will depend on how you define ESG. While there remains no consensus about what the details of ESG are in measurable terms, there is growing agreement on what the concept itself means.
"The basic theory behind ESG investing is that a company's returns may be impacted by environmental, social, and governance factors in addition to traditional financial factors," says Michael James Maloney, a partner at Felicello Law, P.C., in New York City. "The most common environmental issues cited are the effects of climate change like floods or fires. ESG social factors include the impact of a company's actions on 'stakeholders' like employees and communities. ESG proponents argue that fiduciaries should consider the company's actions regarding ESG factors when deciding whether to invest in that company's stock."
Structurally, it's a relatively straightforward process to integrate ESG into a portfolio management system. You can treat it as an asset class or one of several criteria for stock selection.
"ESG is primarily a risk management tool," says Andrew Poreda, VP and ESG senior research analyst at Sage Advisory Services in Austin, Texas. "ESG assessments better help corporations and investors assess risks that have previously been underemphasized by various stakeholders. It can also be used as an avenue to identify opportunities in a constantly evolving landscape."
If you accept the theory of ESG, then you can understand why people believe it's critical to ensuring future prosperity. What, then, is the most important part of ESG?
"ESG investing primarily aims to integrate green and socially responsible factors into a portfolio to generate long-term positive impact," says Andrew Pickett, Attorney at Andrew Pickett Law based in Melbourne, Florida. "By considering a company's environmental, social, and governance practices, investors can make more informed decisions about where to invest their money."
In marrying your value system with your investments, the idea is that ESG will make you (and the world) better off.
"The main purpose of ESG is to provide investors with a framework to assess the potential performance and impact of their investments in an ethical and sustainable way," says Linda Chavez, founder & CEO of Seniors Life Insurance Finder in Los Angeles. "This type of investing seeks to benefit not only shareholders, but also other stakeholders such as the environment, society, customers, employees, and local communities."
In practice, though, ESG does not differ from any other movement or sales pitch. You're either in it (or against it) because of your faith or because of your perceived financial benefit. This represents a classic case of "politics makes strange bedfellows."
"ESG is considered to be a progressive cause," says Maloney. "Proponents argue that traditional shareholder capitalism is too narrowly focused on returns to shareholders while ignoring negative impacts on non-shareholders. ESG is offered as an alternative that expands the scope of issues considered by fiduciaries."
"ESG factors are supported by a wide variety of investment professionals," says Matt Bruce, president of Pointer Financial Group in Wauwatosa, Wisconsin. "ESG is supported by the companies that stand to benefit the most from ESG, specifically those who have strong ESG scores. Additionally, many fund companies charge higher expense ratios for ESG investments and stand to profit from the widespread adoption of ESG funds. Many political and non-profit organizations support ESG investing principles with the belief that ESG advocacy efforts will push companies to adopt policies more in line with their organizational goals. Finally, many investors, especially younger generations, support ESG principles as it gives them an opportunity to do good and avoid harm with their investment dollars."
The first thing you should do here is to create a list of all those who promote ESG to see if you can discern similarities and differences between them. This will help you place them in either the faith (a.k.a. politics) or financial categories.
"In general, the investment industry, investors, climate advocates and Democrats are supportive of this but for potentially different reasons," says Bud Sturmak, the head of impact investing and a partner at Perigon Wealth Management in New York City. "The investment industry supports it because integrating ESG factors into the investment process can lead to prudent risk management and potentially better retirement outcomes for millions of Americans. Investors are increasingly demanding ESG as they are asserting their right as consumers to put their investment dollars into companies they believe in. Climate advocates likely see this as an opportunity to leverage finance as a tool to accelerate the transition to a low-carbon economy and prevent a climate catastrophe. Democrats are likely supportive for all of these reasons."
By focusing on ESG as it pertains to investing, proponents have crafted a way to combine both faith and financial objectives into one package.
"Supporters of elevating ESG factors in retirement investments include a variety of organizations, ranging from environmental groups to labor unions," says Chavez. "They advocate for the inclusion of ESG investments in retirement plans because they believe it is a way to promote sustainability and ethical investing while also providing better risk management, lower costs, and improved returns. In addition, proponents argue that it is important for employers to take into account the long-term effects of their investments on the environment, society, and local communities. By encouraging ESG investment, employers are taking a responsible approach to their retirement plans that can benefit both their employees and society as a whole."
Indeed, it's easier to sustain the faith if you add the financial element to it.
"Many investors, particularly those who are socially and environmentally conscious, support efforts to elevate ESG factors in retirement investments," says Andrew Latham, director of content of SuperMoney.com in Raleigh, North Carolina. "They argue that such factors can help identify long-term risks and opportunities and align investments with personal values. Additionally, many companies are increasingly prioritizing ESG factors, which can help drive financial performance over the long-term. There is a growing body of research that suggests that incorporating ESG factors into investment decisions can lead to better investment outcomes. Several studies have found a positive correlation between ESG performance and financial performance. For example, a study by Harvard Business School found that companies that focused on sustainability outperformed their peers in terms of stock price and profitability. Another study by MSCI found that companies with high ESG ratings experienced lower cost of capital and higher profitability compared to companies with low ESG ratings. Additionally, research by the CFA Institute found that ESG factors can help identify potential risks and opportunities that may impact long-term investment performance."
It should be noted regarding the research cited above that correlation does not imply causation. Further, the research referenced was conducted prior to the latest period, where ESG investment performance has lagged. A more recently published article in the Harvard Business Review states not only do ESG investors suffer from underperformance, but they may also not be receiving the ESG value they had hoped for.
Once again, you'll want to make a list of ESG opponents to see on which side of the faith/financial scale they fall. It may be a sign that the arguments of this side of the debate haven't fully matured, but it seems "cause," rather than "money," is a much more vibrant motivator.
"Republicans and aligned groups are vehemently opposed to ESG," says Poreda. "They view ESG as a subversive way to enact political and ideological goals through investing. ESG is seen as part of a bigger culture war where climate activism and 'woke-ism' are being pushed to a naïve general public through different entities (education system is another example), basically bypassing the governing bodies in our country that are supposed to be shaping these issues through legislation. Banning 'ESG' in ERISA plans is just one step to take this perceived power grab out of the hands of asset managers. Another interesting argument against ESG is that it goes against 'free markets' and capitalism. Whether it be preventing investors from utilizing ESG factors or banning certain asset managers from managing money (like in Texas) due to a supposed boycott of the oil and gas industry, the logical observer would say the group who is putting heavy-handed stipulations in place is the anti-capitalist in the room."
That's not to say money doesn't play a role, although its part may be less direct (i.e., unlike for ESG funds, there's no talk about charging premium fees for non-ESG funds). Ironically, both sides make a play for better long-term returns.
"Some opponents of elevating ESG factors in retirement investments argue that it could limit investment options or reduce returns," says Latham. "They may also argue that considering ESG factors could conflict with a fiduciary's duty to act in the best financial interests of plan participants. Some opponents also believe that ESG investing is politically motivated and could lead to biased investment decisions."
In a line used by proponents, those in opposition to the ESG movement also believe there is substantial support behind them.
"ESG investments are often opposed by conservatives who feel that ESG investments favor one political ideology and pressures companies to adopt 'woke' policies they don't support," says Bruce. "In addition, many investors, who want to maximize growth in their portfolio, would rather not have ESG investments offered which may or may not benefit their retirement savings in the long run. Finally, many companies pressured to adopt policies they don't agree with, oppose ESG classifications as they feel the somewhat narrow scope of ESG categorization doesn't fairly represent their company's products or corporate practices."
You could say that those who are suspicious of ESG have faith they can achieve greater investment success by simply ignoring it.
Those include "people who believe the government should not be involved in choosing allowable investments," says Lyle B Himebaugh, managing partner at GGA Retirement in Stamford, Connecticut. "Knowledge is power. There is no standard ESG benchmark. The people who do not support ESG are the ones who want to make money."
In a nutshell, "opponents to ESG argue that consideration of factors undermines corporate competitiveness and will lead to lower returns for shareholders," says Maloney.
With these differing views and the fact these opinions represent widespread beliefs on both sides of the ESG issue, perhaps the marketplace will be the ultimate arbiter for the ESG concept. Will the idea itself become sustainable, or will it disappear as have other investment fads, or will it ultimately wither away and become a narrow niche like those long-standing portfolio instructions that ban the investment in alcohol, tobacco, and firearms?
Important Information: This communication is marketing material. The views and opinions contained herein are those of the author(s) on this page, and may not necessarily represent views expressed or reflected in other Exclusive Capital communications, strategies or funds. This material is intended to be for information purposes only and is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument.