Should ESG investing be criminalized?

New Hampshire Proposal

Earlier this month, three members of the New Hampshire House of Representatives introduced a bill opposing ESG investing. It reads in part:

Executive agencies authorized to invest funds must review their investments and ensure that funds and state-controlled investments are not invested in companies that invest New Hampshire funds in their accounts based on environmental, social, and societal considerations. We shall take the necessary measures to ensure that. Governance standards.

Hmm. Taken literally, what else should the law be? This provision prohibits New Hampshire officials from investing state funds in portfolio managers who give “any consideration” to “governance standards.” I am. Even as investment professionals fret over companies appointing relatives of CEOs to boards or failing cybersecurity audits, endangering the New Hampshire officials who elected them. and cannot deal with those problems.

(Worse than that, the bill states that anyone investing on behalf of New Hampshire must not give “any consideration” to governance issues.) According to the language of the proposal, portfolio managers: think On such topics. )

further problems

Environmental and social provisions have not improved much. Presumably, the bill's authors are trying to prevent stocks from being selected because their organizations are considered “good corporate citizens” by portfolio managers. But again, the bill's language is far too broad. Companies will therefore be off limits, either paying hefty fines for pollution or facing an impending labor strike.

If any questions remain about the soundness of this proposal, the severity of the penalties should clear them up. The bill states, “This shall be a serious crime punishable by imprisonment for not less than one year and not more than 20 years.'' Now. Her maximum sentence for kidnapping, first-degree assault and sex trafficking in New Hampshire is 15 years. Apparently, none of these crimes are so vile as to warrant allowing a portfolio manager to invest based on her ESG principles.

fundamental problem

Shortcomings aside, this bill raises valid points. teeth What is the outlook for ESG investing? The bill's proponents imply that ESG considerations are doubly harmful, increasing portfolio risk while reducing returns. They argue that state officials have a fiduciary responsibility to “maximize economic benefits and minimize risks.” But state representatives are generalists, not subject matter experts, and their views in this case are clearly partisan.

Instead, consider what an unbiased researcher would believe. By and large, they ignore common arguments. The general debate about ESG investing consists of proponents who argue that considering ESG factors can avoid future difficulties, and opponents who argue that addressing such concerns will hurt profitability. Masu. Home Depot HD co-founder Bernie Marcus said ESG is “all about woke diversity.” “Things that don't lead to the bottom line.”

This is a reconstruction of an old debate. Long before ESG existed, business school professors were debating whether American companies were currently focusing on profitability too much, too little, or just right. Business management inevitably involves trade-offs. How much would you spend today to avoid tomorrow's problems? The accepted answer to this question is “It depends.” This controversy cannot be resolved by theory.

Potential Objection 1: Lower Risk = Lower Return

However, there are also more substantive criticisms of ESG investing. One is to take the claims of ESG advocates at face value. If evaluating ESG issues is just another form of risk management, then funds that invest with ESG principles in mind will hold stocks that are, on average, less risky. However, the answer is that ESG funds will benefit because there is a correlation between risk and return, and the higher the risk, the higher the expected return. few It costs more than our competitors.

fair enough. But this argument undermines New Hampshire's proposal. There is nothing wrong with investing in securities with lower expected returns because the risk is lower. If it existed, it would only allow portfolio managers to invest in highly speculative securities. For example, it would be illegal to invest in U.S. blue-chip stocks because emerging market stocks carry more risk and therefore better expected returns.

It should also be noted that the link between such theory and practice is very tenuous. All things being equal, this commandment is reliable, but all things are rarely equal. Therefore, its explanatory power is weak. For example, U.S. blue chip stocks have beaten emerging market stocks in recent decades.

Potential objection 2: More popularity = less revenue.

Another argument against investing based on ESG principles is that so many investors are attracted to companies with high ESG scores that the prices of such securities are inflated. Due to its popularity, it has performed well in the past, but future returns will likely be low. Pay more and get less.

This argument is also reasonable. That is certainly the case if the facts support it. But it's not clear.For example, Morningstar conducted an in-depth study of global stocks over an 11-year period from his 2009 to his 2019, and found that the stocks with the highest he ESG scores were cheap than our competitors. On average, dividends were higher and price-to-earnings ratios were lower.

Moreover, popular asset pricing models, although logically sound, are difficult to implement. After all, stocks outperform while becoming overvalued before they become too expensive and lag behind. Is ESG the first or second step? I can't answer that question. Furthermore, if the answer is that ESG stocks are still in the first tier, their expected returns will be relatively low. expensivenot low.

Potential Objection 3: Actual Performance

Because so many parties (including Morningstar subsidiaries) publish ESG risk scores and investment performance can be measured over many time periods, people in many countries can reach the conclusions they want. . And that's what's happening, as ESG investing is both a highly politicized topic and one that can have significant benefits for its proponents. Both sides have released reports that seem to confirm their beliefs.

Therefore, those studies are set aside. I'm sure a lot can be estimated, but I'm getting conflicting results, so I conducted my own research instead. I sifted through all the large-blend US stock funds with a 5-year track record (longer would have been better, but 10 years ago there were very few ESG funds) and divided them into four groups. We categorized them into: 1) Index Non-ESG Funds, 2) Index ESG Funds, 3) Active Non-ESG Funds, and 4) Active ESG Funds.

I wanted to present four results, but I couldn't do it well. The non-ESG funds included in the index included several “low-volatility” funds that modified traditional strategies, thereby reducing returns for the group. Instead, I decided to introduce his two largest index funds in the industry, Vanguard Total Stock Market ETF VTI and Vanguard S&P 500 VOO. Vanguard also offers an index-type ESG investment, “Vanguard ESG U.S. Stock ETF ESGV,” so we included that as well.

(Despite potential objection 1, we omitted the risk measure because the standard deviations of returns for all groups were similar.)

The result is the Rorschach test of investing. If you see ESG funds or their rivals winning, that's what you want. One won the indexing battle, the other won the active battle, but neither yielded significant results. No conclusions can be drawn from such small differences.

Now, if you want to fix a New Hampshire bill that jails officials who employ active portfolio managers…