A Better Case for ESG

Editor’s note: This article first appeared in the Q1 2022 issue of Morningstar magazine. Click here to subscribe.

Advocates of sustainable investing have been quick to promote recent evidence of outperformance of environmental, social, and governance funds. Their enthusiasm is understandable but probably unwise in the long run.

It’s easy to see why ESG supporters would want to respond to long-standing claims of ESG underperformance from their critics. They’ve withstood a lot of cheap shots over the years. Anti-ESG sentiments are deeply rooted among the more traditional investment commentators who think that capitalism should not be bridled by nonpecuniary concerns, such as social progress. Such sentiments have prevailed for as long as I’ve been following the financial markets. I recall a “study” done by a conservative business magazine in the late 1980s or early 1990s that looked at the five largest socially conscious funds of that era. It examined the trailing performance of the group and found that collectively they trailed the broad market averages. Thus, the study concluded that investors who wanted to make the world a better place should ignore ESG concerns in their investment decision-making and instead simply invest for the highest return, and if they felt guilty about their profits, then just make charitable contributions to soothe their consciences.

What the study ignored was that two of the five chosen funds were balanced funds that held significant fixed-income positions. Given that they were examining a bull-market period where equities outperformed bonds, this sample of just five funds, two of which held lots of bonds, was doomed to fail the performance test the magazine had set up. Moreover, the test ignored the reality that any five actively managed funds chosen at random would likely trail a cost-free index. (In fairness to the magazine’s editors, the benefits of indexing were much less widely grasped at that time.) Nevertheless, the study and its rather pompous conclusion that investors shouldn’t worry their pretty little heads about social or environmental causes was hardly supported by the evidence they assembled.

Similar anti-ESG sentiments continue to percolate through the investment discussion. One current attack asserts that only governments have the power and authority to make meaningful changes to social and environmental issues, so the investment community shouldn’t even bother trying to advance these causes. Of course, those making these claims also tend to be those who are least likely to support government actions on these issues. Their aim is not to enhance government action, but to discourage all efforts. Even if one rightly concedes that governments must play an essential role in ESG progress, that hardly means that businesses can’t make significant contributions as well or that investors do not have the right to align their preferences with their investments.

The recent outperformance of technology stocks, which tend to have better ESG scores, and the concurrent underperformance of generally lower-scoring fossil fuel energy stocks—two trends enhanced by the work-from-home conditions of the pandemic—give ESG stocks a recent performance tailwind. It’s understandably tempting for ESG proponents to seize this opportunity for revenge and stake a claim to superiority. But winds change direction, and basing the case for ESG on favorable short-term performance is as foolish as shunning it for periods of underperformance, as advocated by ESG critics. And while the argument that money flowing into ESG funds could fuel outperformance among ESG stocks is tempting, it’s wise to recall that investment flows into funds tend to chase, rather than cause, stock-price movements. Longer term, a better case for ESG revolves around investors’ rights to have their investments reflect their beliefs and in the potential for that connection to increase their commitment to their investments, thus both increasing the potential number of investors and upping their collective willingness to stick with their investments through tough times.

When a portfolio becomes a cause, investors are apt to be more dedicated to it. Wise fund companies have long recognized this possibility. Look how Vanguard and DFA strive to create cults around their passive investment philosophies or how American Funds has worked to create dedicated communities of financial advisors who are deeply steeped in their investment philosophy. Wise corporations do the same, seeking to make employment at their firms seem like part of a bigger cause or mission and not just a paycheck. People want to believe they are part of something bigger, that their actions have significance to the world around them. ESG-themed funds hold the potential to forge such bonds.

Of course, there’s no guarantee; other factors like manager celebrity have failed to keep investors onboard. Investors quickly abandoned many star managers when their performance faltered, and even index investors have run hot and cold, as seen by the huge inflows into large-growth index funds in 1999 and the exodus from those funds after the tech stock collapse. Still, I believe that ESG connects in a firmer way and has the potential to deepen the commitment investors have to their portfolios and thus help them stay the course when others abandon ship. The story ultimately may be told by the money-weighted investor returns, not by time-weighted performance calculations. If that’s the case, then ESG investing will be performing a valuable social good—helping improve the long-term finances of a new generation of investors by not forcing a divide between their financial and social or environmental goals.

Don Phillips is a managing director at Morningstar. He is a member of the editorial board of Morningstar magazine.