[This post grew out of a WCI Forum discussion where a new poster was concerned about the ethics of investing in all stocks, including those companies whose missions the investor disagreed with. Chris Hughes, CFP, a wealth advisor with the Del Monte Group took exception to the tack that most of the forum participants took on the topic and decided to submit a guest post arguing his point of view. His submission will constitute the “PRO” portion of this post, and I will take the “CON” point of view. We have no financial relationship.]
Pro — Dispelling Common Objections about ESG and Impact Investing
Environmental, social and governance (ESG) and impact investing are not well understood – and rightfully so, given they are relatively new on the scene. In a conversation on the WCI Forum, several comments typify the objections and questions that people have about this topic: it’s too expensive, doesn’t create real benefit to society, and underperforms. These are many of the same concerns voiced by the population at large. This article will offer fact-based rebuttals to these objections that this discussion failed to consider.
Objection #1: ESGs are More Expensive and Underperform Regular Stocks
WCI Forum comments:
“You can look up ESG funds and try to find a good one…It will definitively have higher expenses and likely have lower returns.”
“You can dig down deeper and do socially responsible investing and/or impact investing, but these options get more expensive. Heck, there are companies like SEI who design Sharia, Baptist and Catholic portfolios. They are not cheap but they are an option.”
“Unfortunately, most normal people are priced out of best social options.”
“Your fees are likely to be higher and your returns are likely to be lower. You will be donating money to Wall Street that could have gone to provide for your favorite charities doing good in the world.”
Performance and Fees
I can’t argue about the performance of sustainable investing for a few reasons. One, there isn’t as much long term data available upon which to base these conclusions. Conventional market data goes back 90+ years. We’re still in the nascent stages of ESG and impact investing and have less than 20 years of data to judge.
It’s obvious that having an ESG portfolio custom designed as a separately managed account is going to be more expensive and prohibitive for investors who fail to meet the minimum size. This doesn’t mean that you can’t engage in sustainable investing through mutual funds (or even better, ETFS) on your own. ETFs tend to carry lower expense ratios than mutual funds and the number of sustainable ETFs is rapidly growing in response to market demand.
Here’s where critics’ views can be a bit myopic, however. In general, you stand to lose way more value by improper asset allocation, poor tactical decisions such as market timing, failure to diversify, and lack of attention paid to tax sensitivity. These are the factors that move the needle way more than any one investment bearing slightly higher fees or slightly lower performance.
Do you realize that taxes are the single largest transfer of wealth that any person will ever experience in their lifetime? Yet how many high earning people with substantial investment portfolios sit down with their tax advisor once or twice a year and actually look at things such as:
- The best way to use tax loss carry forwards for the year
- If tax loss harvesting of concentrated positions is necessary
- What they are losing by being in certain mutual funds that make distributions whether or not the shares actually go up
- How much they are paying in capital gains tax by being in high turnover funds that sell positions at a gain that they may or may not personally have a gain from
- Whether or not their bond holdings are triggering AMT
How many people use a financial advisor who is also a tax advisor? This would provide ongoing tax advisory which would allow for maximum efficiency. Yet few people do. Most advisors are not also tax advisors and they pay very little attention to taxes other than at the end of the year.
Asset allocation refers to the mix of stocks, bonds, derivatives, and cash in your portfolio. Investments fluctuate in the short term, but having the portfolio aligned with your risk and return goals is what is ultimately going to be responsible for getting you where you want to be in the long term. If you want proof, check out this pension study (study link no longer available) which shows that “investment policy dominates investment strategy (market timing and security selection), explaining on average 95.6 percent of the variation in total plan return” (Brinson et al., 1995).
Objection #2: ESG Investing Doesn’t Actually Create an Impact on the Company
“All you accomplish by investing in these funds is making yourself feel good while simultaneously harming your expected future net worth.”
“Your stake in a company through a mutual fund isn’t what is allowing that company to do bad things. You own fractionally none of it from a statistical standpoint. It’s the littering equivalent of dropping a paper gum wrapper on the ground once every 3 months.”
“Your money isn’t going to the company and its founders unless you’re buying it at an IPO. It’s going to the last guy who owned it, probably a mutual fund or pension. You’re not hurting anyone or affecting anything by avoiding investing in the stock of a “bad company.”
Several Ways Investors CAN Influence a Company
If stock price didn’t matter, then why should management care? I agree; there would be no point in trying to influence stock price if it had no impact on the company’s wellbeing. But in reality, there are several ways that it does.
- Having positive momentum on the stock price bodes well for companies seeking equity (or even debt, for that matter) financing. Better financing means that the company can pay down debt, fund growth projects, and even enact a merger or acquisition more readily.
- If there’s not enough demand for the stock, a company may have to sell additional shares to gain capital funding. This may lead to share dilution which impacts the holders of existing shares. It then becomes a never ending cycle of more people dumping the stock causing more downward pressure on the stock price.
- The street looks at stock price as a barometer for the performance of its management. Falling shares and the perception of shareholder disapproval, to a large enough extent, results in the Board of Directors giving leadership the ax. Remember that the Board of Director is voted in through proxy by you, the shareholders.
- While it’s true that shares are exchanged from investor to investor without directly putting cash in the company’s pocket, a lower stock price hurts compensation if management is holding stock options. When the shares are in the tank, the options have no value.
- Falling share prices are often the target of media attention and negative press never helps any company.
Objection #3: Too Hard to Attack One Particular Problem
“There are no truly bad companies. Take the armaments sector that you don’t want to support… If you exclude such companies, what you are left with may not produce the market returns.”
“Your ‘bad companies’ are completely different from someone else’s. And the chances that your list overlaps precisely with that of a mutual fund manager is essentially nil. The world is a very gray place.”
Focus on Companies that Create Positive Outcomes
Most investors fail to realize the difference between Environmental, Social and Governance (ESG), impact investing, and Socially Responsible investing (SRI). ESG and impact investing look to promote companies who do good for society. SRI, on the other hand, excludes companies that are not socially beneficial.
I agree that an SRI approach can be so limiting that market-level returns become impossible. If you were to exclude every single company that offends some ESG criteria, it becomes pretty hard to reap the return that the market has to offer. And moreover, given that everyone’s personal preference is different, customization may be expensive.
If this is your concern, then focus on companies who create positive outcomes rather than avoiding those who do bad. You’ll find way more options that way, and fund companies are only increasing their offerings as a response to burgeoning demand. There are several mutual funds and ETFs that focus on a particular purpose (e.g. encouraging women or minorities in management, clean energy, etc.)
Impact investing is still in its early stages and is by no means perfect, but most of the objections people have about participating are based upon conclusions that can be debunked upon closer examination.
I'm not sure this CON section even needs to be written. Between the quotes cited above and Mr. Hughes's own comments, I think he debunks most of his own arguments. Longtime readers know I am not a fan of Environment Social Governance Investing (ESG), Socially Responsible Investing (SRI), Impact Investing, Sustainable Investing, or whatever its next name will be for reasons explained well by forum participants above. However, it seems worthwhile to make a few comments about Mr. Hughes's rebuttal.
Impact is Expensive Active Management
At risk of going “ad hominem”, when you see an article like the one above, the first thing you should do is ask yourself, “Self, who goes to the trouble to write an article like that?” And the logical answer should be “Someone who benefits financially from convincing you to invest in this manner.” Is that the case with Mr. Hughes? I'll let you be the judge, but there is an entire page on his firm's site about “Sustainable Investing” where the firm encourages you to invest in this way.
That sounds awesome, doesn't it? You can change the world. Who doesn't want to help the environment? Who is against being socially responsible or governing well? Nobody. I mean, everyone likes cupcakes and unicorns. But let's peel off the marketing here and look at what is really going on. A good place to start with any advisory firm is the ADV2. In this case, we'll take a look at Item 5 (Fees) and Item 8 (Investment Strategies) for Mr. Hughes's Del Monte Group advisory firm.
Let me summarize for you. This firm charges its clients AUM fees of up to 2% per year and has chosen not to reveal how that AUM fee is determined or where break points might be either in its ADV2 or on its website. Aside from the fact that 2% is twice the “industry standard” 1% (which is already far too high for anyone with a seven figure portfolio), it is pretty obvious that the firm is not going to compete with its competitors primarily on price. (There's a reason the fees are not prominently posted on the website.) So it must find something else with which to distinguish itself from its competitors. Perhaps that “something else” is “Sustainable Investing.” Let's move on to the investing strategies of the firm.
It doesn't actually say anything about impact investing there, but I would presume from the website that their strategy is at least partially based on Impact. I've looked at a lot of these and this one is much more vague than most, but as near as I can tell, the firm's main strategy is to pick stocks, bonds, and mutual funds that the firm's crystal ball says will do well in the future. Its two strategies involve holding on to investments for either more or less than a year. I don't mean to be critical, but it's hard to take anything else from the firm seriously when this is how the ADV2 describes their work. Maybe they didn't expect anyone to actually read this, I don't know.
For those who are new to this whole investing thing, this is called active management, and it doesn't work. One of the reasons it doesn't work is because it costs so darn much. How much does it cost? Well, the “Top 5 ESG Funds” recommended by Kiplinger have expense ratios ranging from 0.65% to 1.01%, 16-33 times as expensive as just buying all the stocks at Fidelity, Schwab, or Vanguard via a Total Stock Market Index Fund. Are the ESG ETFs any better? Not according to Forbes. The cheapest of their “Best Socially Conscious ETFs” costs 45 times a total market ETF, plus they are small and illiquid–good reasons to avoid any ETF. Now add those fund or ETF expenses on to the advisory fees of a firm like Mr. Hughes, and you're already looking at a hurdle of 2-3% that the active manager has to overcome. Now handcuff him with an “Impact Mandate” and your chances of long-term outperformance against a true index fund rapidly approach 0%.
So, in reality, your choices are:
B) Hire an expensive manager to pick an expensive fund or ETF (or worse, choose the stocks himself) and not have enough money to retire comfortably yourself, much less be able to support a charity. Instead of your money going to support charity, it is going to Wall Street.
The choice is yours. However, Mr. Hughes is certainly correct when he says “We can’t argue about the performance of sustainable investing” because the track record of active management is terrible and is highly likely to continue to be terrible. ESG funds are probably too new to really say how terrible, but the record of SRI funds demonstrates that active SRI funds are about as crummy as active non-SRI funds. Hughes's counterargument, that other things like asset allocation, taxes, and fees matter more, is silly. That's like saying after your heart attack not to worry about your hypertension because your diabetes and your smoking habit matter more. In reality, ESG investing is just a new way for Wall Street to sell you active management by appealing to your emotions. “It's your duty to get lower returns in order to save the planet and society.” I call B.S. As noted by Reuters,
“Investors in ESG products tend to be more patient and care less about performance than investors in traditionally-managed products, so there might not be the same push to pull assets when a product has underperformed.”
ESG-focused funds have been one of the few bright spots for the actively-managed fund industry at a time when lower-cost ETFs and passive index funds are drawing assets, in large part since sustainable strategies often require more research and stock selection that is not easily replicated in an index….Financial advisors who focus on ESG investing say that they expect that index providers will create more tailored products, such as the SPDR SSGA Gender Diversity ETF and the iShares MSCI ACWI Low Carbon Target ETF, that will draw more investors out of actively-managed funds.
Active management still doesn't work, even when you pair it with unicorns and rainbows. These are the kinds of ETFs that Jack Bogle warned about.
Exchange-traded funds are overrated and in some cases flat-out dangerous….
When you get into ETFs and their rapid growth, it has certainly become a marketing business. We now have one that’s short retail and long electronic marketing. Talk about a product of the times…And we’ve got the Republican and the Democratic ETFs, and the drinkers and the distillers. And where it ends nobody knows.
ETFs have become the new way to speculate…even though many ETFs are in fact index-based. There's a lot of niche-seeking…There's a lot of junk out there.
However, in all fairness, I must concede a point here that I did not expect to have to concede as I started to write this post. Are there social INDEX funds? There are. Vanguard has one (and a new ETF or two.) Its returns are actually not too bad. (Beats the 500 index over 10 years, but not over 15 years.) So if you do decide to do Impact Investing, stick with passive investing as usual. But it does NOT appear that we have proven conclusively that just having an Impact mission definitely causes lower returns. The main problem, as usual, is high fees from advisors and high costs and poor performance from active managers. If you can avoid those two things, perhaps it isn't crazy to try to invest “responsibly.”
Impact Investing Doesn't Make a Difference To Stock Price
Mr. Hughes argues that lower stock prices do matter to management. I find that argument weak but plausible. Where he fails to convince, however, is that Impact Investing actually lowers stock prices for “bad companies,” that it actually has an impact. If the ESG funds avoid the stocks, the Sin funds pick them up. In case you're wondering, Sin funds outperform ESG funds, but both underperform their respective index fund. But the point is that just because YOU don't own these stocks doesn't mean nobody will. In fact, the more the stocks of these profitable companies are avoided by investors, the better investment the stock becomes. Remember what a stock is–a share of a company and its profits. Buying those profits at a lower price per dollar of profits is a good thing. If you really want to hurt a company whose mission you disagree with, then boycott their products, not their stock.
One Person's Good Stock is Another's Bad Stock
Bad companies are in the eye of the beholder. The military vet might despise a marijuana company and love a firearms company. The local hippie might love marijuana and hate guns. Mr. Hughes's argument against this, that you should just buy the good companies instead of avoiding the bad companies, is like something out of Alice in Wonderland. Buying shares of a tiny illiquid ETF that only buys shares of companies that have minorities in management isn't going to change a thing other than transfer money out of your pocket into that of the Wall Street croupiers who think you're dumb enough to buy what they're selling.
Want to change the world through investing? You will do a lot more good by buying low-cost index funds and donating the excess returns to charity than you will by purchasing expensive, thinly-traded ETFs or individual stocks and donating the excess returns to the financial services industry.
What do you think? Do you engage in Sustainable/ESG/SRI/Impact investing? Why or why not? Comment below!