12 Dec The New Fund in Town
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.
Clearing the Air
There’s a new fund in town – according to The Financial Times – and it aims to give investors a choice about putting their money in companies that favor Diversity, Equity, and Inclusion (DEI). While the fund may, indeed, give investors that choice at some point, what it does more immediately is give your humble correspondent a chance – once again – to address some of the lingering confusion about social investing, ESG, and the imposition of “values” over value in contemporary capital markets.
Let me start – naturally – at the beginning. What is the fund? Who will be running it? And what do they promise?
A new fund aiming to punish “woke” companies will make Starbucks its first target, as politically motivated investors move to capitalise on Donald Trump’s election.
The actively managed fund, which Azoria Partners expects to launch early next year, will exclude S&P 500 companies that incorporate diversity, equity and inclusion considerations into their hiring processes….
Unlike an activist hedge fund, which buys stakes in companies to agitate for change, Azoria will push its agenda by excluding companies from their index and publicly claim DEI policies are hurting their stock price.
Let’s clear up some confusion right away. Unfortunately, FT starts this article with a lie. It says the new fund aims “to punish ‘woke’ companies,” which is absolute nonsense. Rather, as I said above, the fund aims to give investors a choice, and specifically, it aims to improve their returns. One could argue that decapitalization – which is what the new fund promises – might, hypothetically hurt a corporation, but that’s extremely unlikely in this case. FT notes, for example, that the “fund does not manage any money yet.” Not to state the obvious, but it’s hard to punish anyone or anything with 0$ in AUM. More to the point, even when it has assets under management, this particular fund won’t do much to “punish” Starbucks, which has a market cap. of over $110 billion.
Perhaps this bit is simply poorly edited and neither the paper nor the article’s authors (Amelia Pollard and James Fontanella-Khan) meant to say that the fund will purposefully “punish” companies. But even if that’s the case, all FT has done here is sow confusion.
Additionally – and more importantly – this has nothing whatsoever to do with ESG. FT claims that “[t]he new fund is the latest attempt by Trump-supporting investors to push back against DEI and environmental, social and governance initiatives” and that “[t]he strategy borrows from so-called environmental, social and governance funds, which excluded investments in polluting industries and were attacked by many conservatives.” None of this is true – not even close.
To reiterate, there are differences between traditional Socially Responsible Investing (SRI) and Environmental, Social, and Governance investing (ESG). The most important of these is that the former is “voluntary,” while the latter is “coercive.” What does this mean? Mostly what it means is that SRI is a divestment/decapitalization strategy, in which investors simply opt out of certain companies, while ESG is an engagement/coercion strategy, in which investors (or the asset managers that manage their assets) attempt to “force behaviors” (as Larry Fink, infamously put it) on corporations. SRI is says, “we don’t like what you do, so we’re leaving.” ESG says, “We don’t like what you do, and because we are large shareholders, you will change what we tell you to change.”
It also means that those investors who engage in SRI’s decapitalization strategy do so fully aware of what they are doing, why they are doing it, and what it might mean for their returns. By contrast, those who engage in ESG’s coercion/engagement strategy are not always fully cognizant of the ends to which their invested wealth is being used and, if they were, might object to it being used in that fashion. Indeed, this is one of the premises underlying the lawsuit filed two weeks ago by 11 states against The Big Three (BlackRock, State Street, and Vanguard). As I noted this past weekend, ESG is an issue in this case because it affects:
tens of millions of Americans whose IRAs, 401(k)s, public pension funds, and other retirement savings are being used by the massive investment firms to create the leverage that they use to coerce corporations. This is the thing that’s so important about the 11-state suit: it identifies the issue that large asset management firms would rather remain unidentified, the fact that Americans’ saved wealth can be used to harm them and to strongarm corporations into making decidedly poor business decisions, specifically because that wealth is concentrated in so few hands.
Bringing this back around to where we started, this new fund from Azoria Partners is not an ESG fund. It is not intended to be coercive or engagement-oriented. It does not buy shares to use as leverage to force corporate behavior. In truth, this new endeavor is a good, old-fashioned SRI fund, the type of fund that has been around for decades and that was largely uncontroversial until just recently.
The one thing that makes this new Azoria fund different from other traditional SRI funds is that it promises increased returns. As I noted above, historically, SRI has carried a warning about potential diminished returns. It has always promised to allow investors to sleep at night, comfortable in the knowledge that their investments are aligned with their values, yet fully aware that that alignment comes at a price. By excluding certain stocks or, more often, certain sectors from their portfolios, these investors understand and acknowledge that they will likely see lower-than-market-average returns over time. That’s simply the nature of the game, and it is a tradeoff socially responsible investors have long made.
The Azoria fund is different, though, in that it promises higher returns because of its divestment criteria. It does so based on the idea that Diversity, Equity, and Inclusion principles are detrimental to a company’s operations, that such practices result in lower-quality hires, overall, which, in turn, reduces the company’s effectiveness, profitability, and stock price. Or, as one of Azoria’s co-founders James Fishback put it, “human capital hiring quotas — that hurts all shareholders.”
Although this is a controversial claim in some highly politicized circles, most people would likely concur that it makes logical sense. Hiring based on anything other than pure merit will, presumably, result in poorer performance over time. The catch for Azoria is that while the claim may make logical sense, it will be very hard to prove. It’s appealing to believe otherwise, but that doesn’t make it true. If the Azoria fund excludes Starbucks and then outperforms the S&P, its managers will be tempted to boast that their strategy of exclusion worked, that Starbucks was a drag on the S&P overall, and that they were right to exclude it from the fund. And while they may, indeed, have been right to exclude the stock because it underperformed, they won’t be able to demonstrate in any serious way that its underperformance had anything to do with DEI. Maybe coffee shops in general are underperforming right now. Or maybe there is another problem at Starbucks that is causing its issues. The underperformance of the company’s stock relative to the rest of the market is evidence only of its underperformance relative to the rest of the market, nothing more. Claiming otherwise could be seen as misleading.
This is one of the great unresolved and under-discussed issues with investments that purport to achieve a social end – whether that end is politically liberal or conservative. Proving that a social matter affected stock performance – to the upside or the downside – is incredibly difficult. Historically, actively managed ESG funds have been heavy on tech stocks, which means that their performance has waxed and waned with the performance of the tech sector more generally. That performance doesn’t prove, one way or another, the impact of ESG criteria. Likewise, the anti-DEI strategy may outperform, or it may underperform, and in neither case will that definitively demonstrate anything about the impact of DEI.
It is important to maintain clarity here and to be aware that stock or index performance can be affected by multiple, sometimes related, often unrelated factors. Proving the effect of a single determining factor would require a well-designed, long-term model capable of controlling for all relevant variables. To date, such a model has not been created. Claims to the contrary are, in part, what have exposed many ESG supporters as charlatans and political actors. Likewise, the folks at Azoria should be aggressive in their management and application of principles but reticent in their rhetoric.
