ESG funds have done extremely well recently with, according to bloomberg.com, experiencing capital inflows of $45.7 billion in the first quarter of 2020 alone. Environmental, social, and governance investments clearly are all the rage these days, many of them having outperformed their traditional counterparts in recent years. Many ESG funds invest heavily in technology, but it has to be noted that the rise in technology stocks is not necessarily related to ESG. The same rationale applies to oil stocks: ESG investors avoid this sector, but the fall in the oil-price particularly in 2020 is also due to a lack of demand because of the COVID-19 pandemic. So is ESG maybe just another bubble bound to burst at some point?
In a now famous essay published in the New York Times in 1970, Milton Friedman stated that ‘in a free-enterprise, private-property system, a corporate executive is an employee of the owners of the business. He has direct responsibility to his employers. That responsibility is to conduct the business in accordance with their desires … the key point is that, in his capacity as a corporate executive, the manager is the agent of the individuals who own the corporation … and his primary responsibility is to them.’ So, to put it bluntly, companies should be focusing solely on maximising profits for their shareholders and leave it to them, if they so wish, to spend their money n social causes. Friedman argued that an executive spending company money on social causes is, in effect, spending somebody else’s money for their own purposes.
ESG based assets are now estimated to have reached some $40 trillion globally and the trend to do the right thing even seems to have accelerated during the pandemic. Particularly younger investors seem to have taken to the idea of sustainable and socially responsible investing. The hectic pace of the growth has, by its very nature, caused some sceptics to question the sustainability of the rally, and a number of financial analysts are doubtful that all of the stocks which have been pushed to new heights will really be able to meet their investors’ expectations.
Boohoo, a U.K.based online fashion retailer aimed at 16 – 30 year olds is a good example: in July 2020 the company found itself at the centre of a scandal concerning its use of what could effectively be called sweatshops. Even more unsettling was the fact that these factories were not somewhere in Asia but in Leicester, a city just about 100 miles north of London.
Driven by liquidity and flows, ESG investing has become to some extent a self-fulfilling prophecy as it is raising the cost of capital for “bad” companies and lowering it for good ones. But can this trend last? What is going to happen once socially and environmentally responsible investment funds stop outperforming the broader market? Asset managers who have a fiduciary responsibility to maximise their clients’ returns will have no choice but to chase the most attractive investment opportunities irrespective of ESG credentials.
Similarly for businesses: Once the various government sponsored support schemes related to the pandemic come to an end, many organisations will find their finances strained. And many management teams will come to the conclusion that in the short term at least value for money may count more than being ecologically and socially responsible.
Another problem is how ESG credentials are being measured. Dozens of different approaches by investment managers, banks and independent service providers mean that there is a wide array of scores and indices out there. Which criteria to include in a score and how to weight these is often not least a matter of personal preference and interpretation, as is shown in an article by Goldman Sachs Asset Management with the apt title ‘measuring the immeasurable’. So how reliable are these indicators?
There are many ways to score a company on environmental, social, and governance criteria, making the results difficult to compare. ESG ratings also allow to assess how climate change or a discriminatory workplace may affect future corporate performance and thus the share price. The trouble is these risks are hard to measure and rarely disclosed. Rankings are difficult to compare as ESG analysis by its very definition is subjective as different providers will have their own, individual ways on classifying the various criteria. And only time will tell, which assessments proved right in the end.
And that some assessments are blatantly wrong is again proven by the case of Boohoo: Just weeks before the story about the sweatshops broke, one major ESG data provider had given the company one of its highest ratings, making it clear that it saw the company miles ahead of its competitors as far as its ESG credentials were concerned.
For investors it may therefore be worthwhile holding off for a while, rather than chasing the latest ESG touted fad. Service providers were obviously eager to be among the first to offer scores, rankings and methodologies to an investment community only too eager to be seen doing the right thing (or in this case, investing in the right stocks). Come time, markets and investors will learn to separate the grain from the chaff.
The grumpy older man 