19 Oct The Broken Central Promise of ESG
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.
A poor Woodman was cutting down a tree near the edge of a deep pool in the forest. It was late in the day and the Woodman was tired. He had been working since sunrise and his strokes were not so sure as they had been early that morning. Thus it happened that the axe slipped and flew out of his hands into the pool.
The Woodman was in despair. The axe was all he possessed with which to make a living, and he had not money enough to buy a new one. As he stood wringing his hands and weeping, the god Mercury suddenly appeared and asked what the trouble was. The Woodman told what had happened, and straightway the kind Mercury dived into the pool. When he came up again he held a wonderful golden axe.
“Is this your axe?” Mercury asked the Woodman.
“No,” answered the honest Woodman, “that is not my axe.”
Mercury laid the golden axe on the bank and sprang back into the pool. This time he brought up an axe of silver, but the Woodman declared again that his axe was just an ordinary one with a wooden handle.
Mercury dived down for the third time, and when he came up again he had the very axe that had been lost.
The poor Woodman was very glad that his axe had been found and could not thank the kind god enough. Mercury was greatly pleased with the Woodman’s honesty.
“I admire your honesty,” he said, “and as a reward you may have all three axes, the gold and the silver as well as your own.”
The happy Woodman returned to his home with his treasures, and soon the story of his good fortune was known to everybody in the village. Now there were several Woodmen in the village who believed that they could easily win the same good fortune. They hurried out into the woods, one here, one there, and hiding their axes in the bushes, pretended they had lost them. Then they wept and wailed and called on Mercury to help them.
And indeed, Mercury did appear, first to this one, then to that. To each one he showed an axe of gold, and each one eagerly claimed it to be the one he had lost. But Mercury did not give them the golden axe. Oh no! Instead he gave them each a hard whack over the head with it and sent them home. And when they returned next day to look for their own axes, they were nowhere to be found.
— Aesop, “Mercury and the Woodman.”
Moral: Truth will be rewarded, while dishonesty and greed shall be punished.
An Axe to Grind with ESG
EDHEC is one of France’s best-known and most respected elite business schools. Over the last few years, the school, its scholars, and its associated institutes have done invaluable work, critically investigating and, as a result, piercing some of the most persistent myths surrounding ESG. This month, Gianpaolo Parise and Mirco Rubin, EDHEC professors of finance and econometrics, respectively, have produced another in the school’s long series of empirical ESG studies, one that is, perhaps, more damaging to the premises and reputation of the investment strategy than any done previously.
I have long argued that ESG is dead, that its time has passed, and that it continues to be a going concern only because of institutional inertia and government intervention. Note that when I say this, I don’t mean that sustainability is no longer an issue for asset managers and corporations or that the ESG funds are all going to be closing up shop in the immediate future. Indeed, my pronouncement of ESG’s death long predates its recent struggles with asset outflows and fund closures.
What I mean, rather, by the “death” of ESG is the inarguable exposure of its principal promise as a lie. At its heart, ESG pledges to enable investors, asset managers, corporate executives, government officials, and others to “do well by doing good.” The problem, of course, is that this promise is disingenuous. It is a lie – on both ends. ESG neither enables investors to do well (versus the broader market, at least) nor does much good (in terms of the environment, social measures, or empowering important stakeholder groups).
Over the years, the evidence supporting this claim has continued to mount. The study by professors Parise and Rubin not only adds to this ever-growing compendium but does so in a rather dramatic and reproachful way. Coining the term “green window dressing,” they write:
While certain investors hold the belief that sustainability is a panacea, delivering both superior returns for themselves and a better world for all, academic research has consistently cautioned that there is no free lunch. Scholars have emphasised time and again that ex-ante, a fund cannot be inherently responsible and simultaneously deliver consistently superior performance (Gantchev et al. 2022, Ceccarelli et al. 2023). While responsible investing can align with ethical values and promote positive societal impacts, it forces fund managers to shun high-performing yet controversial assets, such as those issued by polluting firms or by businesses operating in ‘sin industries’ (Hong and Kacperczyk 2009, Kacperczyk and Bolton 2021)….
Yet, sustainability used to be in the eye of the beholder. Is Tesla sustainable? While Tesla cars do not pollute, Tesla’s record on workplace practices and occupational safety is unimpressive. It is easy enough for asset managers to make an argument in favour of Tesla stock if they wanted to buy it, or against it if they did not want to. This changed in 2016, when Morningstar became the first company to start assigning ratings to funds based on how sustainable their disclosed portfolios were. In its most popular version of such ratings, Morningstar ranks funds from one globe (the least sustainable funds in their category) to five globes (for the most sustainable funds). These objective and easy-to-interpret metrics have been a game-changer for a segment of the industry still lacking regulation and transparency.
The ratings also changed managers’ incentives: it doesn’t look good if you run an environmental, social, and governance (ESG) fund and you are ranked poor in sustainability. Despite the positive impact on the industry, sustainability ratings have one limitation: they rely on portfolios disclosed by the funds themselves. In the US, funds are legally required to disclose their portfolios four times a year (at the end of each fiscal quarter), with some voluntarily disclosing more frequently, up to 12 times per year. In most European countries, disclosure is obligatory at least twice a year. Although this provides some transparency, it still means that investors only know with certainty the assets held by their funds on four days per year in the US and two days per year in Europe.
What assets do ESG funds hold during the rest of the time? The infrequent disclosure of portfolios poses a challenge as it opens the possibility for a fund to strategically purchase ESG stocks just before disclosure, thereby earning a high sustainability rating, and subsequently shifting to higher-yielding yet less responsible assets when detection is unlikely. In Parise and Rubin (2023), we explore this trading practice, which we refer to as ‘green window dressing’. Due to the lack of daily observations of fund holdings, we infer them from fund returns, as returns are reported daily. The intuition behind our approach is as follows: if a fund primarily invests in ESG stocks, its performance should closely correlate with the main ESG indexes. When ESG stocks perform well, the fund should also excel, and vice versa. However, we demonstrate that the correlation with ESG indexes drops significantly right after mandated disclosure, while a sudden increase in correlation appears with stocks of high CO2 emitters. This behaviour indicates that some funds engage in green window dressing with benefits for their performance and ability to attract investors.
We also document substantial but short-lived asset pricing implications….[We show] that high-ESG stocks deliver positive cumulative abnormal returns (CARs) in the days leading up to fund disclosure, consistent with the notion that fund managers bid up their prices when attempting to greenwash their portfolios. Yet, the sudden surge in prices swiftly reverts after disclosure, suggesting that fund managers either cease to purchase high-ESG assets or divest from them altogether.
As a final piece of evidence, we calculate the hypothetical returns a fund would earn based on the disclosed portfolio and compare them to its realised returns….[W]e observe that in the ten days leading up to disclosure, funds tend to underperform the portfolio they are about to disclose. This observation is consistent with the idea that, during this period, they incur meaningful transaction costs as they adjust their portfolio to include more environmentally friendly and sustainable assets. However, following the disclosure event, we notice a shift in performance dynamics. Funds begin to outperform the portfolio that they have just disclosed, indicating that they are now holding higher-paying assets than the ones they have recently made public. This trend is in line with the hypothesis that after the disclosure event, funds might replace some ESG assets with higher-yielding but less sustainable assets.
My apologies for the extended quote, but this is important. Indeed, if the conclusions drawn here are accurate – and I have no reason to believe otherwise – this blows the lid off the entire universe of actively managed ESG funds. It exposes the entire multibillion-dollar ESG-management industry as something sordid and grotesque, not noble and empowering, as it is billed.
Think about the implications. Not only do ESG funds perform so poorly against the broader market that managers feel compelled to resort to trickery and deception, but they are also not really ESG funds. They are ESG in name only. On all but four occasions (or two, in Europe), they are no different in means or ends than any other actively managed fund in the world – or at least they’re no better, morally.
A couple of weeks back, I asked, somewhat theatrically, if “ESG is a Scam.” I concluded that “there are well-meaning and honest people throughout the…industry,” but the “biggest players” behave in such a way and at such a volume that they “drown out the rest of the players.” This study by Parise and Rubin strongly suggests that I had that right. In fact, it goes well beyond that, implicating a significant percentage of active ESG managers in the commission of fraud, in a legal sense.
To be clear, the model used in this study is clever and informative. It appears to make logical sense and to be well specified. Nevertheless, Parise and Rubin are careful to concede that the model was created specifically to compensate for the non-existence of the hard data they would otherwise like to examine. Of course, that’s the whole point. ESG funds are not required to disclose the data necessary to prove the hypothesis definitively, which is both why the model is needed and why the industry is – according to the model – a largely fraudulent undertaking.
That said, this is social science and almost nothing is definitively provable. The study appears plausible, however, and if its results are replicable, then it may be as close to “proof” as one can possibly get.
And if that’s the case, then the validity of the central promise of ESG is eroded even further, as it becomes clear that the second half of it – the part about “doing good” – was always meant to be a way to dupe well-meaning but woefully naïve investors and nothing more.
Gianpaolo Parise and Mirco Rubin, may not exactly be Mercury (the Roman god of finance and commerce, among other things), but they do have substantial power here, the power to expose those who would lie and cheat to satiate their greed.
