10 Oct A Paradigm Shift in Ethical Investing
The following commentary/analysis is one I wrote in my capacity as a senior fellow at “the nation’s oldest consumer protection agency,” Consumers Research, where, among other things, I compile a weekly letter for public pension-fund managers. I am sharing it here today because I thought it might be useful to some of you.
The Academization of ESG Continues Apace
About three months ago, I noted that the nature of the ESG debate is changing and that the change will likely cause even more heartburn for the investment strategy’s supporters. Specifically, I suggested that the debate over ESG was undergoing “academization,” meaning that, “[g]oing forward, it is highly unlikely that any discussion of ESG performance will be considered valid unless and until it is confirmed or, at least, buttressed by academic research.”
This, I suggested, would be both good and bad for those who seek the truth®, largely because academics are both good and bad. Some are earnest, honest, and driven by a search for knowledge, while others are ideological hacks who use research only to confirm their preexisting biases. In the end, however, the presence of the former would alter the perceptions of ESG in profound ways, making it far more difficult for its supporters to continue to undermine shareholder rights and fiduciary duties in the name of political endeavors.
Among the academics cited in that note was Alex Edmans, a professor of Finance at the London Business School and previously a tenured professor at Wharton. Edmans’ then-new book, May Contain Lies: How Stories, Statistics, and Studies Exploit Our Biases—and What We Can Do About It, had taken a blowtorch to many of the premises underlying ESG. Although a “man of the Left” himself, Edmans understands just how destructive it is when “experts” fudge data or use poorly designed models to reach conclusions that are at odds with reality. Therefore, he wants to change the debate surrounding ESG to focus on what is real and provable rather than what some people “feel” is right and “just.”
Well, Edmans is back with a new paper, and this one…is a doozy.
Edmans – along with Tom Gosling, his colleague at the London Business School, and Dirk Jenter, from the London School of Economics and Political Science – surveyed “509 equity portfolio managers from both traditional and sustainable funds on whether, why, and how they incorporate firms’ environmental and social (“ES”) performance into investment decisions.” What they learned is somewhat counterintuitive, somewhat reassuring, and, for supporters of ESG at least, completely devastating.
The researchers conclude their analysis with five “takeaways”:
Their first conclusion is that “that the dominant objective of investors, including sustainable investors, is financial performance.”
Only a minority of investors are willing to sacrifice any returns for ES performance, and very few would tolerate a substantial sacrifice, largely due to fiduciary duty concerns….In reality, most stock selection, voting, and engagement decisions are taken by asset managers (agents), whose objective function is purely financial.
That is both counterintuitive and reassuring. I couldn’t be happier to hear it.
Their second conclusion is about “the importance of ES constraints, which frequently dominate both financial and social reasons for considering ES performance.” The key bit here is that these constraints “may fail to induce asset managers to improve companies’ ES performance: while they can prevent errors of commission (e.g., investing in tobacco), they are less able to prevent errors of omission, such as not engaging effectively on ES issues.” Or to put it another way: it’s hard for ESG strategies to move beyond the normative benefits of traditional Socially Responsible Investment practices.
Conclusion number three is that there is significant “heterogeneity of beliefs, and actions motivated by beliefs, among investors.” This, I think, is a pretty common-sense finding. People do different things for different reasons. They also sometimes do the same things for different reasons and different things for the same reasons. That’s the nature of man.
Edmans and company’s fourth conclusion “is that differences between typical traditional and sustainable investors are smaller than commonly thought.”
Both recognize the priority of financial returns and of delivering on their fiduciary duty, and both view long-term shareholder value as the main reason for engaging on ES issues. Majorities of both will not tolerate companies sacrificing returns to improve ES performance, and majorities of both have never voted for a shareholder proposal that was even slightly negative for firm value. The differences that exist tend to result from differences in beliefs (e.g., on whether ES leaders outperform) or constraints (e.g., from fund mandates).
While this too is nominally reassuring, it does make an important point about the necessity of winning the battle of ideas and beliefs. Too often, I think that those of us who oppose ESG belive that “winning” this fight is simply about winning electoral majorities, passing laws, and making bold statements about duties and responsibilities. What we need to understand as well is that the ESG practitioners don’t disagree with those bold pronouncements, which is why enforcement of laws and regulations has been spotty and very difficult. At the grassroots level, this is about culture and beliefs, and to “win” here, we must do the same on this issue as we would on any issue. We must change hearts and minds by making superior arguments and presenting compelling evidence. We must change the culture first.
Finally, the researchers reach their fifth, and most important conclusion: “our results call into question whether the asset management industry is likely to have a significant effect on companies’ overall ES performance.”
I said this paper was a doozy, right?
Most fund managers, including sustainable ones, are reluctant to sacrifice returns for ES, and most do not believe that firms are systematically investing less in ES than optimal for shareholder value. Consequently, without a change in fund managers’ objectives, the industry is unlikely to lead the charge to improve firms’ ES performance.
I have long argued that the core promise of ESG – that investors can do well by doing good – is a lie on both ends. ESG investors neither do better than other investors nor do they do much good, at least as they define it. Edmans et. al confirm this conclusion here, but with a twist: the reason ES investors don’t do much good is that their agents/managers are bound by law and duty to do well. The two are largely incompatible, and doing well takes precedent.
What this suggests is that those who truly wish to use their resources and investments to “do good” should look beyond ESG. They can target their investments more directly or they can accept and explicitly agree to do “less well” than they would otherwise. Whatever the case, Edmans et. al suggest a paradigm shift in thinking about “ethical” investing.
I said the academization of ESG would change things, and we’re only just getting started.
