23 Aug Near-Term Outlook for ESG
Again, the following commentary/forecast 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.
Hard Times Ahead for ESG
One of the crucial differences between traditional Socially Responsible Investing (SRI) and Environmental, Social, and Governance investing (ESG) is the promise made by practitioners to investors about their expected returns. For years, SRI promised investors that they would be able to live with themselves, that their consciences would be eased, and that all it would cost them would be a few percentage points on their returns. SRI was honest and practical, acknowledging the investment truism that limiting the universe of investable positions would, on average, also limit returns.
ESG vendors, by contrast, have never been quite as realistic or forthcoming. They have never conceded that their strategy might, over time, limit potential returns. The claim that ESG enables one to “do well by doing good” has never been honestly qualified to acknowledge that while an investor might, indeed, do well using ESG, he will not, over time, do as well as he would have otherwise.
The evidence for this is overwhelming – although rarely, if ever, admitted. In his May 2021 report for the RealClearFoundation (which I reviewed here), longtime environmental analyst Rupert Darwall laid bare the truth about ESG and its alleged ability to produce the same or better returns than traditional investment strategies. Moreover, as countless analysts have shown, much of the positive returns generated by ESG are the result of portfolios that nearly perfectly overlap tech portfolios, meaning that the positive returns are a function of investment in good companies, not ESG strategies. Or, as Aaron Brown, a former managing director at AQR Capital put it in his May 7, 2021 Bloomberg column:
Want to align the core of your investment strategy with climate-change values? Or build a sustainable equity portfolio for the long-term by focusing on environmental, social and governance goals? A variety of ESG exchange-traded funds have made these and other promises. But…they mostly hold the same large capitalization technology stocks as the S&P 500 Index, represented in the top row by a popular ETF with a minuscule 0.03% expense ratio, in similar weights.
Not only are the portfolios similar, but performance is nearly identical. The Vanguard ESG fund has a 0.9974 correlation to the S&P 500 fund since inception in September 2018, which is higher than most index funds have to their benchmarks. A correlation of 1 would mean the two funds run perfectly in sync.
Despite all of the evidence (and despite Modern Portfolio Theory), a significant percentage of ESG investors – at least in the United States – have bought into the case made by ESG advocates, which is to say that they expect that they will be able to get rich(er) by saving the world and fixing its social ills. They expect their returns either to beat or, at least, match overall market returns. As The Wall Street Journal noted just last week:
[A] new study examining attitudes and expectations about environmental, social and corporate-governance investing found evidence suggesting that many investors who own ESG stakes themselves expect those investments to outperform the U.S. stock market.
The paper, published in April by the National Bureau of Economic Research, a nonprofit research organization, was written by researchers at Yale University, Stanford University, New York University and the University of Pennsylvania’s Wharton School, and an investment strategist at Vanguard….
Among all respondents, 45% saw no reason to invest in ESG and generally expected such investments to underperform the market. Twenty-five percent reported that ethical considerations were or would be the primary motive to invest in ESG, and as a group they predicted the investments would underperform the market by 0.8 percentage point a year, on average, over the next 10 years. Twenty-two percent cited hedging against climate risks as the primary motive, and they, too, expected market underperformance….
[O]nly about 3.5% of all respondents owned any ESG-focused funds. But on average, these respondents expected the 10-year return on the investments to outperform the market by nearly 0.3 percentage point a year.
“Investors who report higher expected returns from ESG investments hold a higher share of ESG funds in their portfolios,” the researchers conclude. “Investors who are more optimistic about ESG returns invest more in ESG funds,” they add.
Given all of this and given market forecasts for the remainder of the year and into 2024, it seems likely – one might even say extremely likely – that the American ESG sector is headed for seriously troubling times. Relatedly, the clash of cultures between ESG regimes in Europe and the United States, respectively – which was noted in this column two weeks ago – is therefore likely to grow even more unfriendly.
Granted, market forecasting is not easy, even for professional market forecasters. And I am NOT a market forecaster, professional or otherwise. Nevertheless, the consensus seems to be that the tech sector will likely cool down considerably from its hot start this year. As MarketWatch noted last week:
As technology companies look forward to big opportunities in artificial intelligence, this latest earnings season seemed to reveal some cracks in their present-day armor.
Technology stocks have pulled back in August after the sector racked up seven months in a row of gains to start the year. Recent weakness comes amid renewed skittishness about interest rates, which is pressuring more expensive, rate-sensitive names, but it’s also worth paying attention to what companies have said about the health of their industries lately.
Namely, executives used their recent earnings calls to highlight a number of challenges, including a slower-than-expected recovery in China, sluggish consumer-electronics demand and more cautious approaches from some enterprise customers.
If you couple this with the fact that fossil fuel companies are working harder than ever to attract investors and regain their historical share of the S&P’s market valuation, it is not difficult to imagine that ESG portfolios will underperform significantly over the next quarter or two (or more). American ESG funds have already experienced five straight quarters of outflows, even as tech stocks soared and their returns rebounded from a miserable 2022. If tech underperforms the market going forward, and if fossil fuels outperform (or even just match the markets as a whole), then it is all but inevitable that ESG funds will trail the markets as well, further exacerbating their problems.
Meanwhile, ESG funds in the EU also saw net outflows in the second quarter (only the second quarterly outflow in a decade), in part because of concerns about ESG’s political troubles in the United States. Regulators, environmental activists, and other ESG advocates are likely not to take kindly to this “interference’ – albeit unwitting – from the United States and may well step up their attacks on American regulators and companies. Already this summer, the U.S. Treasury and the EU’s commission for financial markets and services have exchanged harsh words over what the EU sees as American intransigence on ESG reporting regulations. Continued difficulty in the American ESG sector and continued spillover into the EU market would undoubtedly exacerbate already significant tensions.
All things considered, then, the near-term forecast for American ESG is pretty dim. Likely reduced returns, significant ongoing outflows, and increased global tensions all suggest that the sector is in for a very bumpy ride over the next several months at least.
