If You Are Not Already an ESG Investor, You Probably Will Be

The Back Story Once upon a time, there was socially conscious investing. Socially conscious investing was primarily punitive, meaning that rather than rewarding companies for being good, it disqualified them for behaving badly. It came in two flavors: religious and political. Religious prohibitions included avoiding firms that loaned money at interest or that were involved in birth control. Divesting from businesses that operated in South Africa was a common political screen.

It seemed that socially conscious investing directly refuted the prevailing investment doctrine of shareholder value, which stipulated that firms should care first, foremost, and perhaps even solely about creating value for their investors, by finding ways to increase their stock prices and/or dividends. Instead, for socially conscious buyers, a company's first task was to be ethically acceptable.

This arrangement ensured that socially conscious investing would be a fringe movement, because it positioned the practice as curbing profitability. Socially conscious investors sought to restrict corporate activities, thereby reducing a company’s ability to make money. To be a socially conscious investor was, in effect, to wear a hair shirt. It was a sacrifice that one made for the greater good.

Big Smoke, Small Fire The reality was somewhat different. No matter how strict their screens, socially conscious investors could nevertheless own most equities, meaning that their opportunity sets remained extensive. What's more, socially conscious investing didn't truly threaten the precept of shareholder value. It merely added an initial screen. Organizations that passed the initial test were free to operate as before.

Socially conscious investing was more fuss than feathers. It impassioned its supporters, while annoying Wall Street and most of the business press, but it neither attracted much money nor altered many corporate decisions. Neither did it meaningfully affect investor returns. On average, the total returns for socially conscious equity funds closely matched those of customary funds.

For publicly traded companies, socially conscious investing was a hostile act, a directive imposed from the outside. Corporate managements were always likely to reject its edicts, unless the pressure became so intense that they could no longer resist. But the pressure rarely became intense. By appealing to investors’ consciences rather than their wallets, the socially conscious movement limited its ability to attract assets. It never became large enough to pose a legitimate threat.

New Millennium, New Ideas Enter environmental, social, and governance, or ESG, investing. Unlike socially conscious investing, the practice of ESG investing was invented from within, and it dangles carrots rather than brandishes sticks.

The concept was popularized in 2004, when former United Nations Secretary-General Kofi Annan invited financial institutions "to develop guidelines and recommendations on how to better integrate environmental, social, and corporate governance issues" into asset management. Participants included Goldman Sachs, Credit Suisse, Morgan Stanley, and Deutsche Bank, with funding provided by the Swiss government. It was a who's who of the global elite.

As these organizations represented outside shareholders, they weren’t technically insiders. But they were the next closest thing--establishment investors from similar backgrounds as CEOs, holding similar values. They would meet quietly, behind the scenes, with corporate managements, rather than publicly denounce companies. There was no need to shout, as their reputations and asset bases assured them of an audience.

And they came bearing gifts, at least from their perspective. Critically, ESG investing does not propose being good for goodness's sake. Instead, it advocates being good so as to become rich. The founding document is entitled "Who Cares Wins." The middle word, to use Margaret Thatcher's term, is squishy; but that which follows is not. Dame Thatcher would have strongly approved of winning.

She would not, however, have approved fully of ESG’s principles. The “G” is noncontroversial. Encouraging companies to make their board of directors more independent, to improve their accounting standards, and to upgrade their audits can only help outside shareholders. Those are clear investor benefits.

Politically Charged In contrast, the "E" and "S" provisions involve politics. The "E" less so, because outside the United States, the global business community tends to agree that climate change is a threat that requires corporate attention. The social section, though, contains items that will surely distress those with a libertarian bent, such as prodding firms to increase their workforce diversity, or encouraging them to improve their connections with local communities.

Allegedly, these suggestions are best business practices, not personal preferences. Companies that follow ESG's axioms are said to be sustainable. They preserve the environment in which they operate; maintain healthy rather than predatory relationships with their customers and employees; and avoid the pitfall of corruption. They are better positioned to thrive for the long haul than are firms that respond to shareholders' short-term desires.

Such is the theory. In truth, as with all recommendations of corporate best practices, ESG’s guidelines are based on a pinch of proof--it’s devilishly difficult to demonstrate how a single factor (for example, a company’s level of workplace safety) affects stock-market performance--and a heap of faith. The approach appeals to science, but inevitably it reflects its authors’ collective political views.

Aiming High As, of course, did the doctrine of shareholder value. Which leads to the central point: Unlike socially conscious investing, ESG investing seeks to be more than prohibitive screens. Its goal is far more ambitious. From the outset, the intention of ESG's proponents was to create a comprehensive set of fiduciary principles that would replace the precept of shareholder value, as the single global standard.

In that task, it likely will succeed. To be sure, there remain many vocal supporters of the concept of shareholder value in the United States. But ESG investing has become mainstream elsewhere, and even within the U.S., it has scored major successes. For example, the world's largest asset manager, BlackRock, strongly supports ESG investing, as does the nation's biggest pension fund, CalPERS.

We all, I suspect, will become ESG investors.

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.