Edinburgh has a new Library of Mistakes – a financial library devoted to helping us all learn from the disasters of the past. Over the past week it has been running a series of events designed to discuss those disasters; Wednesday was devoted to the mistakes of fund managers. There have been a few.
Some brave managers told us of their awful stock picks (Northern Rock loomed large), but the real mistakes were ones of wider groupthink and the over-enthusiastic embrace of shifts in investment thinking – believing in the ability of the internet to support any valuation going in the late 1990s, or in the new paradigms on offer just before the financial crisis, for example.
What was not discussed was the huge mistake today’s fund managers are making: the fervent embrace of the idea that investing according to environmental, social and governance (ESG) principles is both a good thing and something that guarantees long-term outperformance.
ESG investing has been adopted with enormous speed and zeal
One of the most extraordinary things about this is the speed and zeal with which it has been adopted – despite the data being too short-term for any reliable conclusions (money only started to flow into ESG strategies in real volume in 2015), and the definitions of what counts as ESG being simultaneously so fluid (there is much regulatory movement, but still no set of universal standards) and so rigid (everyone creates their own standards and adheres to them via a strict box-ticking regime) as to be verging on nonsensical.
Take Twitter as an example. You can look up most companies online and see an ESG rating for them with Sustainalytics. Twitter is rated 19.4. This means it ticks a lot of boxes and is therefore a “good” investment. No surprise, then, that it turns up in most ESG exchange-traded funds.
But stop to think about this, just for a second. The fuss around Elon Musk’s takeover of the company centres in large part on free speech concerns – and his apparent full embrace of it. This should be a reminder that Twitter hasn’t been much of a supporter of free speech over the past few years – just ask anyone who deviates from what its moderators consider acceptable views on, say, vaccine efficacy or gender ideology, or indeed Donald Trump.
It might also be a reminder that free speech is not just a good thing in theory but an essential driver of equality, democracy and, perhaps, of successful capitalism. Let’s not forget, writes Jacob Mchangama in his book Free Speech, that in allowing everyone to challenge the elite, “free speech may well be the most powerful engine of equality ever devised by humankind”. If you really believe in democracy and equality – and the S in ESG – do you want to be invested in a company that messes with that? Of course you don’t.
You might even ask why there isn’t an H for human rights in the whole thing (EHSG, anyone?). You can pull out a good percentage of the companies in the average ESG portfolio and make a similar argument.
ESG is fine if it makes you money
Still, maybe you don’t mind pretend do-goodery if your box-ticking is sure to make you money. But it isn’t. The average ESG fund has not had a pleasant 2022 so far, thanks to the underperformance of the growth stocks that make box-ticking easy against the oil and mining firms that definitely do not.
Meanwhile, a recent paper from researchers at the University of Chicago was unable to find any evidence that “high sustainability funds” outperform low sustainability funds. Indeed, perhaps the opposite is the case: there is some evidence that companies focus on ESG to cover for poor business performance.
The strategy has also proved itself to be fairly worthless as a risk indicator (one of its great selling points is supposed to be that, if done correctly, it at least highlights the future risks to a company). Yves Bonzon, group chief investment officer at Julius Baer, who I suspect is something of an ESG apostate, notes that “prior to the outbreak [of war] average ESG ratings for companies with extensive operations in Russia were higher than those of their peers without such exposure”.
Even in March this year, says Amati Global Investors, Refinitiv, a representative ESG scoring provider, was giving Rosneft, the Russian oil group, a significantly higher ESG rating than Serica – a North Sea company providing 5% of the UK’s gas supply. Lots of boxes ticked; no value gained. Whoops.
But it can be a useful tool
Perhaps, says Bonzon, it is time for investors to “grasp that ESG is not about achieving systematic outperformance”. Its merits lie elsewhere, he notes. “It can be a useful tool for investors to express their values in portfolios and hence derive additional non-monetary benefits from investment activity.”
Thoughtful observers will not be convinced by this bit either (think back to the problem of figuring out what and how to measure). But in any case, what 2022 has brought so far is some pretty strong hints that the idea that ESG is some kind of investing win is dead.
Continuing to invest as though it were a big win is going to create the need for many new bookshelves in the Library of Mistakes. It is time for investors to stop ticking and start thinking.
• This article was first published in the Financial Times