Why ESG Investors Stand To Lose Not Only Their Principal But Their Principles As Well

If there’s one thing Wall Street is good at it’s giving people what they want and finding a way to make the most amount of profit on it in the process. The history of this industry is rife with examples and they are so widespread and well known I won’t go into detail here. Suffice to say the financial industry exists to meet demand from investors which is largely driven by fads.

In recent years, these two prongs of the financial industry fork, giving people what they want and finding a way to profit from that, seemed to come into conflict. Investors demanded passive products intended to limit the amount of profit their providers could extract from them.

So ETF creators had to get creative. And when profit is on the line, Wall Street can be even more creative than Madison Avenue. Evidence of this is the fact that we now have more indexes than stocks in the market. While it might be hard to believe, it’s true.

And in creating all of these new indexes and convincing investors to buy products tied to them, Wall Street has very cleverly pulled the wool over their eyes once again. Because once you buy something other than the index, as it is traditionally defined, you are no longer a passive investor. What’s more, you no longer gain the primary benefit which is rock bottom fees.

Investors utilizing products outside of a total stock market fund have thus unwittingly become active investors paying fees several the times those of a total stock market fund. Still, while some made this switch without much convincing many resisted and remained truly passive.

Wall Street clearly needed to find a more convincing sales pitch and with ESG I believe they have found it. ESG simply stands for Environment, Social and Corporate Governance-focused investing and it adds a bright ribbon of high moral fiber to what would otherwise appear to be a standard growth fund.

And this bright ribbon has become very effective at selling shares in ESG funds. The Financial Times reports that inflows into ESG funds quadrupled in 2019 from 2018. Bloomberg reports that the inflows so far in just the first month of 2020 have already surpassed the entire annual amount seen just two years ago.

While broadly equity flows have actually been negative, ESG flows are soaring. If you wonder why, all of a sudden, Larry Fink, CEO of BlackRock, is now a proponent of ESG wonder no more. As a fund provider, you either create and promote ESG funds or your business is now in decline.

Investors have clearly swallowed the “morality” angle of these funds hook, line and sinker. To be clear, it’s not the intentions that are at fault here; it’s the execution. And you must look beneath the labels in order to understand what I mean.

Take DSI, for example, the iShares MSCI KLD 400 Social ETF, one of the most popular ESG funds in the market today. Morningstar reports, “The underlying index is a free float-adjusted market capitalization index designed to target U.S. companies that have positive environmental, social and governance (“ESG”) characteristics.”

Looking at its holdings, a pair of observations immediately jump out. First, Facebook is its third-largest holding and counts for more than double the weighting in a total stock market index. I must ask, ‘How can a company that is responsible for facilitating genocide, not to mention many other social ills it promotes, be the second largest holding in a socially-responsible investment fund?’ And how many other holdings so blatantly violate the fund’s mandate?

Second, it’s not just Facebook. Microsoft, Alphabet, Cisco, Adobe, Salesforce.com, Nvidia and others are weighted twice what they are in a broad market index. So, again, I must ask, ‘How is this any different from a technology sector fund?’ The answer is that it also holds oversized positions in “quality” consumer-focused companies like Proctor & Gamble, McDonald’s and Coca-Cola.

Set aside, for a moment, whether you believe these are socially conscious companies. The holdings in this fund are quickly starting to look like any active mutual fund that leans towards “quality” and “growth.” But because it is tied to an “index” the fund provider can sell it as if it were a morally-superior passive investment product. Voila! A magical money machine for BlackRock with an expense ratio 10 times greater than a total stock market index fund.

Understanding this dynamic of funds flowing out of equities on a broad scale and a select group of “quality” and “growth” stocks seeing massive inflows as a result of the popularity of ESG helps to explain the massive divergence between growth and value of late.

Ultimately, as a fund manager told Bloomberg recently, “There is a rush to invest more and more money in a very narrow set of assets, which to me look incredibly overvalued, that fills certain ESG criteria.” Because that criteria overlaps to a great extent with “growth” and “value” these stocks are catching a persistent bid while those outside of the criteria are left for dead.

Why has energy performed so poorly of late? Funds broadly have been net sellers as a result of redemptions and all the hot money going into ESG hasn’t bought a share. Conversely, why has tech performed so well of late? While funds broadly have been net sellers here, as well, the massive tech overweighting in ESG funds has ensured a steady demand for their shares.

Energy stocks now represents just 3.8% of the S&P 500 and far less in ESG funds. At its peak in 2008, it weighed in at 16%. Technology now counts for 20% of the S&P 500, not counting communication services (the sector home for Facebook, Alphabet and Netflix) which amounts to another 10%, and nearly a quarter of most ESG funds are allocated to tech with another 13% in communications services.

The popularity of ESG, then, has served to pour salt in the wounds of value investors and fill the sails of growth investors. This dichotomy has grown to the point at which the 10-year performance gap between high-p/e stocks and low-p/e stocks recently eclipsed the record set at the peak of the dotcom mania, prompting even the “pioneers” of value to question whether it has died as a valid form of investing.

Of course, the boom in ESG funds is not entirely responsible for these trends but it certainly appears that it has exacerbated them. And, based upon the true nature of these funds, they may prove to be the final hurrah of the relative bull market in growth versus value.

Like any other investment boom, investors are first drawn to a concept, in this case a morality angle, and then inflows result in performance gains which seem to validate the original concept in a virtuous circle. At some point, it goes too far and it unravels. Only then is it seen for what it truly is: just another investment fad in which the boom invariably leads to bust.

What will lead this fad to bust is the same thing that will lead the broader mania in equities to bust. It could be recession. It could be a black swan. Who knows? But the bust in ESG funds will be more painful because of its concentration in the most overvalued segments of the stock market.

But even more painful for investors in these funds will be the inevitable realization that their good intentions were for naught. I have argued that passive investing has undermined its most basic assumption by way of its popularity. Paired with this trend, take ESG investing to its logical extreme and the same can be said of it.

As Bloomberg reported recently, antitrust officials are looking at the correlation between the concentration of ownership in public companies as a result of passive investing and falling competition. When one investor owns shares in number of companies within a single industry it is in their interest to encourage mergers and other anticompetitive behavior that increases profit margin.

ESG investing concentrates the ownership of these companies even more than purely passive strategies and, further, in a select group of industries. To whatever extent this advantages capital over labor can it be said to still be for the broader social good? I think not.

After it’s all said and done, ESG investors may find they concentrated their investments into the most overvalued segments of the market and invalidated their original premise in process. They will find they have lost their principal and their principles at the same time while Wall Street, as always, found a way to extract its pound of flesh.

Far better for those looking to do well by doing good would be to overtly become active investors rather than covertly. Pick the company that best exemplifies whatever ideals you are looking to promote and tie your fortunes to it, come hell or high water and do this across a number of industries that suit your sensibilities. Only that way, can an investor truly claim to be ESG.

However, that would require people to truly put their values ahead of their avarice. And when did that ever happen on Wall Street?