Last updated on September 29, 2020
Often people say “If everyone sells, that will show them”, perhaps referring to tobacco or oil companies. Not true.
Xavier Baraton, global chief investment officer for fixed income at HSBC GAM
From a money-making perspective, there is something to be said for investing in ESG funds. ESG accounting and rating is highly flawed at the moment, but it will improve, and good ESG ratings will increasingly become a signal for rising stock prices and lower risk.
However, if you are looking for your money to have an impact, you are better off investing elsewhere. Although you may have a minor influence through shareholder engagement, trades in the stock market have virtually no influence on the real world.
ESG funds – the financial argument
Let’s start with the positives.
Of course, the focus by companies and investors on Environmental, Social and Governance goals is a welcome change of tack for all beings that do not benefit from capitalism (which, after COVID-19, must now include even the ultra-rich to some extent).
On top of that obvious starting point, a number of academic meta-studies have proven that a focus on ESG will improve a company’s bottom line long-term (Clark, Feiner, Viehs 2015 – Friede, Busch & Bassen 2015). Investing with an ESG focus will also lower portfolio risk.
Seeing the flaws in how ESG is evaluated and applied right now (more on that later), you should take these studies with a grain of salt. Not all ESG has an equal impact on profits. Nonetheless, there are a lot of signs and they are all pointing in roughly the same direction. So if your goal is to earn as much return on your money as possible, at the lowest possible risk, buying ESG funds is not a bad idea.
However, if you want to invest in ESG stocks because you want your money to align with your values and have a real-world impact, then you can do much better.
Let’s see why.
Why ESG funds are pointless for impact investors
Money in the stock market does not reach the company
When you buy stocks in the stock market, you are generally buying them in the secondary market. This means, you are buying the stock from someone else who has it, betting that the stock will go up in the future. On buying it, the money goes to the person you bought it from, not to the company.
The company does not see your money, and the rise and fall of the stock’s price has only the tiniest of effects on the company’s business.
In liquid markets, simply buying or selling stocks has little, if any, impact on the cost of capital of a company or anything else. You are merely swapping ownership in a big, liquid capital market. Shareholder engagement is the primary mechanism of impact in public markets.
James Gifford, head of impact investing UBS
So if the price of a stock doesn’t really matter to a company’s ability to raise new money, then why do companies care so much about the stock ticker? Here is a good summary on why stock prices matter to companies. The single most important of those reasons? CEOs care because they own a lot of shares themselves. If the price goes up they become richer.
If you didn’t get it yet, here is Xavier Baraton, global chief investment officer for fixed income at HSBC GAM in the FT, as he advocates the use of green bonds:
“Most of the time when we say we are going to invest in stocks or corporate bonds what we really mean is that we are going to buy them in the secondary market.
We are not investing in the sense of giving a company our cash. The equity or credit has already been issued and whatever happens next is between the buyer and the seller. You don’t invest in Honda when you buy a used Civic.
Thus, it neither rewards nor punishes corporate behaviour whether investors own or exclude shares and bonds in their portfolios.”
Often people say “If everyone sells, that will show them”, perhaps referring to tobacco or oil companies. Not true.
When you sell a stock or bond someone has to buy it from you. There are just as many securities held as before. So every exclusion policy is matched by an inclusion.
Likewise, if you’re deliberately buying an ethical security you’re forcing someone else to sell. (How ethical is that?) And it is not really investing at all, it is just trading.
Of course, equity holders can vote their shares and some campaigns are successful. But companies are seldom hit where it hurts — on their bottom lines.
True investing happens when stocks and bonds are issued. And this is when maximum leverage can be applied. During capital rounds companies and their advisers literally beg for cash. They listen to feedback, adapt strategies and make promises. If you want to make a difference, the primary markets are the way to go.”
ESG investing cannot be passive – shareholder engagement is necessary
As it was hinted at in the previous paragraphs, there are 2 ways that you do make a difference when buying stocks.
The first is when the company initally comes to market during an IPO (Initial Public Offering). If more people are interested in the shares, the price goes up, and the company ends up with more money in its hands. It’s just once, though. Companies can and do sometimes give out more shares later. But these are rare occurrences as well.
The main way for a shareholder to have an impact is as an activist investor. All shareholders have a vote, and thus can have an influence on the direction the company takes.
If, for example, you buy a share in an oil company, at the yearly shareholders meeting you can vote against drilling in the Arctic. Problem here is that, unless you bought a million shares, your vote is of no consequence. Unlike cooperatives, public companies are not democratic: more shares means more votes.
So as an individual investor of modest means, you have no say.
However, ESG funds pool the funds of thousands of investors. So they do have the financial clout to actively engage with companies. The question then arises: do they?
Well, some do, yes, often with the best intentions. To what extent? Best if you press them yourself for an answer. But if a fund has dozens of companies in it, you know the engagement has to remain limited, otherwise the fees for investors will go up – fund managers have big salaries.
Another issue is that ESG funds focus on the companies that perform well on ESG measures, screening out the biggest corporate criminals like DuPont or BP. Although that’s completely understandable, it also means that they are passing up on the greatest opportunity for shareholder activism.
These companies are not going away anytime soon, so to take a stake in them to try and reform them makes perfect sense. One activist group that follows this philosophy is Follow This.
Passive ESG funds?
One type of ESG funds can be ruled out immediately, though – the passive ESG fund or tracker. A discussion on the reasons why I disapprove of passive investing will have to wait, but passive ESG is an absolutely ludicrous idea.
ESG ratings are not nearly reliable enough to use as the base for an algorithm to determine which companies to include in a fund (see below), and once the companies are in, the fund manager promises not to ask any questions to the board to keep the fees down for investors! But I’m sure it will fool some people.
ESG ratings are nonsensical
One important caveat in the whole ESG discussion is the lack of consistent ESG ratings. There is no consensus on how to account for ESG variables, and how to rate companies based on the outcomes.
It’s also just one number. That’s not nearly enough to fully describe the management decisions, supply lines, environmental impact, labour relations, etc. of a complex, multi-billion dollar business.
ESG ratings should be treated as a starting point for fundamental analysis, not as an easy shortcut. Here are 6 ways the current ESG process is failing.
- Disclosure limitations and lack of standardisation: There are no standardised rules for ESG disclosure nor is there a disclosure auditing process.
- Company size bias: Companies with higher market capitalization tend to be awarded higher ratings in the ESG space than lower market cap peers as the first often have the ability to dedicate more resources to prepare more detailed ESG disclosures.
- Geographic bias: Companies domiciled in Europe often receive higher ratings than peers based in the US and elsewhere. The reason why is that regulatory reporting requirements vary widely by region and jurisdiction. For example European law requires companies to report more extensively on ESG issues than other jurisdictions. In addition investors in Europe are more convinced of the materiality of ESG investing resulting in more extensive ESG reporting by European companies.
- Industry sector bias: company specific risks and differences in business models are not accurately captured in composite ratings.
- Inconsistencies between rating agencies: Individual company ratings are not comparable across agencies due to lack of uniformity of rating scales, criteria and objectives.
- Failure to identify risk: One of the purposes of ESG ratings is to evaluate risk and identity misconduct. ESG ratings do not properly function as warning signs for investors in companies that experience serious mismanagement.
Will ESG ratings get better? Undoubtedly, but the fact remains that an ESG number remains an indicator, nothing more, and that ESG funds need to actively engage and investigate.
You are limiting your options
How many companies are there in the world? Millions.
How many of those can you actually invest in through a stock exchange? About 45 000, according to the World Bank.
In other words, your options to invest are limited. There are so many great businesses opportunities out there that the stock exchange does not give you access to.
And, as the World Bank graph shows, the numbers are declining. Less companies are available for the individual investor to take a share in.
The glaring example here are the US stock exchanges, going from 7 322 to 3 671 listed companies in the past 20 years.
As the Financial Times puts it: Capitalism, as it emerged in the 19th century, is dead. Businesses have long ceased to finance their investment through equity markets. Net capital raising in public markets is negative. New issues have been smaller than the amounts taken out in share buybacks and acquisitions for cash, and tangible assets, less important than they were, are typically fungible; they need not be owned by the company which uses them and typically are not.
In short: the stock market is a kind of sports betting shop where you can bet on which CEO will win (as evidenced when the coronavirus lockdowns pushed nearly a million sports betters with withdrawal symptoms into the stock market). But instead of being able to bet on all games, there is only one particular league in one particular sport that you can bet on through this shop.
So where should you put your money instead? I am hoping to add reviews of other investment options that offer more impact in the coming weeks here.
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