I first wrote about Socially Responsible Investing on this blog five years ago. At the time, SRI or ESG (incorporating Environment, Social, and Governance standards) investing was an established industry, but just beginning to enter the thoughts of everyday individual investors.
(I will use “ESG” as a shorthand to represent SRI / ESG / Impact Investing in this post.)
Five years later, ESG investment products have exploded in the marketplace, as well as the capital that flows to these kind of investment products. Thanks to the growth of rating agencies, the data to judge ESG performance is now more accessible to fund managers. The maturity of ETF industry also allows individual investors to access these funds with lower entry and ongoing costs.
As markets experienced a shock this year due to the pandemic, there are also now reports showing ESG investments performed better in this environment.
So has my assessment of ESG investing changed due to these new developments?
Revisit the concept of ESG Investing
In case you haven’t got a chance to read my post from five years ago, I am personally skeptical of the notion that anyone can consistently pick the stocks that perform better than weighted market capitalization index. Sure, in history we’ve seen a few fund managers do this in the last 40 years. However, you can probably count them with two hands.
In my opinion, committing to ESG investing is simply employing another set of factors to pick the stocks. In theory, I do not expect that those factors alone are enough to help you pick stocks with better performance. Evidence from various research do not exhibit clear correlation either, not to mention causation.
Revisit the principals of ESG Investing
Even if you care more about companies’ ESG practice than their financial performance, you should still consider the latter. A company that employs your ideal version of the ESG standards but cannot translate the practice to profitability is not sustainable.
Below are the three points I raised before and what new evidence tells us.
#1: Invest in a small number of companies that are truly profitable, under-appreciated, and also make a difference
The idea is that if you want to pick, be picky. I mentioned that if you truly care about the impact of your stock holdings have on the world, your portfolio should look very different from an index fund, instead of mimicking the market.
I also mentioned that intuitively, if you want the world to change due to our collective investing, eventually there shouldn’t be any outperformance from imposing ESG criteria alone, after everyone is on the bandwagon.
I was surprised to see that five years later, this point is articulated more eloquently by someone with more experience and expertise. He calls it the “Transition Period Payoff” and provided supporting academic evidence. To quote,
“The presence of a transition period, where markets learn about ESG and price them in can also explain why there may be a payoff to more disclosure and transparency on social and environmental issues, by speeding the adjustment. It is perhaps this hope of transition period excess returns that has driven some institutional investors to become more activist on ESG issues and can explain why some have been able to show excess returns from increasing (reducing) their holdings in good (bad) companies.”
(Aswath Damodaran, Sounding good or Doing good? A Skeptical Look at ESG)
To rephrase, ESG investing can be financially rewarding when a smaller group of investors see how the company’s ESG standards directly impact its bottom-line before the general market have caught on. Once more capital flows to the company because of its good ESG practice, it become more difficult for the later investors to achieve the same level of return.
#2: Identify ESG criteria that meets your values and understand how they are defined
While there is a growth of data available to measure ESG, the fact remains that it’s difficult to employ the same standard across the board.
First, everyone defines good ESG practice differently. Second, the companies may not make their practice known through public disclosure, which results in “holes” in raw data. Third, the rating agencies utilize raw data in different ways.
The end result is that a company may get good rating from one agency and bad rating from another in each of the category. Depending on which agency your fund manager uses, you get drastically different portfolio, all in the name of employing ESG standards.
Here’s a good summary of the academic studies that looked at the divergence of ESG ratings from different agencies on the same company. In short, there is no global standard on how to measure ESG impact at the moment. Investors would need to either evaluate all the competitors in this space and pick the ones with methodology that best align with their standards or apply their own methodology on the ESG data they can gather.
So far we’ve only discussed applying ESG standards on equity investing. How about bonds?
Sure if it’s corporate bonds, we can easily apply the same methodology on the parent companies that issue the bonds. (In fact, Vanguard, one of the world’s largest asset manager, just came out with its first ESG corporate bond index fund.)
But how about government bonds? Would US Treasury bonds meet your ESG standards? Or would you unequivocal support your country and divest from other countries? How about foreign government bonds? How do measure the social impact of a government? And how does an administration change a country’s ESG rating? How about companies domiciled in totalitarian regime or countries with weak governance?
These are all the questions ESG practitioners are debating right now.
#3: Know why you want SRI in the first place
At this point you may be thinking, “I’d still rather give up financial return as long as I can only support the companies (or even countries) that meet my standards.”
That is totally fine. I applaud that you know why you want ESG investing in the first place before embarking on it.
In the last few years, ESG investing has become the new fad, evident by the amount of funds flowing into it. But what does it promise? Better portfolio return? Better conscience? Better world? All of the above?
Or by following the label alone, we are achieving none of the above?
We discussed in #1 and #2 how to achieve better portfolio return with ESG investing. If you don’t care about the return, at least you feel better about not putting your money in companies you don’t want anything to do with in your day-to-day activities.
But can this new type of investing really create a better world?
One evidence that it does recently came out of the private prison industry. As public sentiment goes against the idea of private prison in general, the major companies in this industry saw their market capitalization decline, credit rating decrease, and low-cost funding dry up.
It still remains to be seen whether there will be investors with large capital simply don’t morally object to private prison and will swoop in for a good investment opportunity when company lacks funding source. After all, this is what happens with Arms, Tobacco, and Oil companies.
As long as ESG standards come from personal values, you will always find that “a better world” is subjective. There seems to be few interpretations of universal values that we can all get behind these days.
It’s not easy
Like everything that is worth pursing in our lives, doing ESG investing right is not easy.
Unfortunately, I think that’s what the industry is promoting today. You can easily make good investment return, feel good about your decisions, and change the world!
A deeper look would reveal that ESG funds you invest in includes hundreds of companies that you don’t have personal knowledge of other than trusting the rating agencies. Then when some news broke, you suddenly realize a company uses questionable practice in your eyes, but as a small investor you have very little power to demand change, especially when not everyone agrees with you.
The good news is that there is now technology such as direct indexing that allows you to create a portfolio with individual stock holdings while incorporating ESG ratings, so you can bypass the fund managers discretion. Nevertheless, you run into the same data issue we discussed in #2. Do you know enough about the data provider and rating agency to get to the companies that meet your standard?
I still believe that by investing in all through an index approach, I take a stand and responsibility in the world I live in now. To shape the world for tomorrow through investing takes more than passively trusting an industry that has an incentive to market products for profit. Take those 3 principals and do your research so you can be sure you accomplish what you set out to do.
Hi Hui-chin, I love your investing article. I’m a college girl who has a dilemma with my investments. I have accounts with Schwab and TD Ameritrade. I plan to move back to Taiwan after I file the form with USCIS to give up my resident status. (My green card already expired,I’m the process of getting a new one&have a temporary stamp for now) But I’m afraid they would close my accounts if they know I’m no longer a US person or don’t live in US. What should I do?
I also worry that the IRS think I’m still a tax resident in future when I’m not.
Do I have to file Form 8854 before I go? But I have only lived here for 5yrs so far. On IRS site”You are an LTR if you were a lawful permanent resident of the United States in at least 8 of the last 15 tax years.”
Hi Julie, glad you like my articles. TD Ameritrade merged with Schwab, so eventually you may need to merge those two accounts. It’s likely you need to open a new Schwab account for nonresident alien and perhaps transfer your investment there without selling.
If you don’t meet the Form 8854 filling requirement then you don’t need to file. You can file dual-status return (half year resident and half year nonresident if you give up green card in the middle of the year and still have US source income after you give up green card. However, if you truly don’t have income to report after you give up green card, there is no need to do anything. You can always attach a statement with your last US resident return saying you ended your US tax residency. If you still have US investments, eventually you may have to file US tax returns on US investment income down the road.