When ESG Investing Falls Short Of Expectations, There Are Alternatives

Ben Warwick is the Chief Investment Officer at Denver-based Aveo Capital, and the author of Searching for Alpha.

On the surface, what could go wrong with socially conscious investing? The so-called environmental, social and governance (ESG) investing craze, which aims to direct capital to companies with the best environmental, social and governance principles, has grown from a 2004 study sponsored by the United Nations to a movement representing $35 trillion in assets under management.

As it turns out, just about everything.

First off, pitting ESG concerns over the mandate of maximizing return creates the sort of fiduciary mismatch that gives many investors heartburn. ESG funds are typically more expensive, with one study showing that such offerings had an AUM weighted average 0.34% expense ratio, compared to 0.12% for non-ESG marketed funds. This may help to explain why so many investment firms tout these virtue-signaling alternatives, as their extra fees are great for the bottom line.

If ESG funds produced higher returns, these extra fees might be justified. Alas, evidence shows ESG funds tend to hold the same large capitalization tech stocks as the S&P 500. Not only are the portfolios similar, but their returns also track closely with one another. As a result, the performance of ESG funds tends to lag, mainly because of their higher fees.

What about the impact of ESG investing? The intent of the strategy is to make the cost of capital higher for companies that put profit before social gain. This typically includes traditional energy companies, cigarette makers, weapons manufacturers and any other company deemed to be conducting business in non-virtuous industries. Unfortunately, there is strong evidence that ESG proponents—specifically those who invest in companies touting ESG initiatives—do not have any measurable effect on the ability of non-ESG firms to source capital.

Predictably, mixing a politically correct framework with an ineffective investment strategy has caused battle lines to be drawn. BlackRock, the world’s largest asset manager and a staunch supporter of the ESG investment philosophy, has seen an exodus of assets from (mostly) red-leaning states because, in the words of Florida Governor Ron DeSantis, “ESG investing sacrifices returns at the altar of the select few, unelected corporate elites and their radical woke agendas.”

Republicans aren’t the only group irritated with BlackRock. Since the firm also offers non-ESG funds, Democrats are critical of the firm for not doing enough to save the planet. It seems like playing both sides of the ESG coin can have some negative consequences, although collecting fees from both constituents seems to be good business.

Meanwhile, investing legend Warren Buffet has labeled ESG reporting as “asinine” and has recently paid $250 million to increase his stake in Occidental Petroleum. Billionaire investor Sam Zell, in a recent CNBC interview, said, “I didn’t know (BlackRock CEO) Larry Fink had been made God. I just wonder whether America is really ready for Vanguard and BlackRock to control the New York Stock Exchange.” Apparently, the heat got too much for Vanguard, as it recently abandoned the Net Zero Asset Managers (NZAM) pledge, a United Nations initiative intended to curb climate change.

Still, the ESG train keeps rolling. The U.S. Department of Labor announced a final rule that allows 401(k) providers and retirement plan sponsors to consider climate change and other environmental, social and governance factors when they select investments and exercise shareholder rights, such as proxy voting.

Climate risk is an investment risk, don’t get me wrong. But to make a real difference, supporting a cogent energy transition framework seems like a more logical alternative.

Take natural gas, for instance, a clean-burning fuel that plays an important role in the eventual conversion of a greener energy future (once that technology has been fully developed). According to the U.S. Energy Information Administration, China’s and India’s growing middle class will more than double those country’s energy demand by 2035. The bulk of that energy will likely come from crude oil and coal. A great alternative is natural gas, which is a much cleaner burning fuel. But natural gas suppliers in the U.S. have been hamstrung by two factors—the ESG movement, which restricts investment in those companies, and the current energy and infrastructure restrictions of the Biden Administration that were relaxed to some extent.

At this point in its history, the ESG investing craze has proven to be a boon—for consultants, asset managers and other firms able to monetize the virtue signaling of green technology. For the climate, not so much. To make a real difference, environmentally aware investors should consider changing their consumption patterns. Fifty million tons of electronic waste are generated every year, and only 12.5% of it is recycled, according to the EPA. How important is it to have the very latest iPhone? Or consider the rare earth metals used in electric car production. Over time, electric cars produce far less greenhouse emissions than gas-powered vehicles, but their efficacy has greatly increased the longer they are on the road. It’s more earth-friendly to drive the wheels off your Tesla rather than upgrading every few years.

Socially conscious investing captures the attention of investors and firms in today’s market—and may suit your needs as an individual investor. But if ESG is falling short of your expectations, consider the alternatives available to make an impact.

The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.


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