The Risks and Benefits of ESG Investing: The Advisor and the Quant

In this series, we provide our readers with two distinct perspectives on the same topic — one from an academic, the other from a practicing financial advisor.

If you have a question or two, please send them to us. Check out the previous column here.

QUESTION: What are the benefits and risks of ESG investing?

THE ADVISOR — JOE ELSASSER, CFP, PRESIDENT, COVISUM:

There are two ways of looking at environmental, social and governance (ESG) investing. The first is a purely capitalist method, in which an investor uses screening criteria to focus their investment dollars in companies that have made commitments to socially ethical businesses. This is a utilitarian argument; the investment returns earned by shareholders measure success.

The second argument for ESG is essentially an a priori argument. In other words, one recognizes their capital has the power to impact society as a whole, and as such, they are simply unwilling to use their capital to help companies that hurt society as a whole. Others are interested in investing primarily in companies that actively benefit society.

There has been terrific debate from both sides of the argument, with economists such as Milton Friedman arguing that incorporating ESG considerations into the management of the business would reduce the bottom line, and several subsequent studies that suggest companies that treat their employees better actually see improved shareholder returns.

Three things control how companies behave:

Consumers
The labor force
Capital

Consumer behavior can have a massive impact on how companies operate. One of the best examples from my youth was the dolphin-free tuna campaign. In 1988, biologist Samuel LaBuddle filmed hundreds of dolphins dying in tuna nets. The footage was enough to shock the public into joining the tuna boycott, and led the largest tuna producing companies to stop poor fishing practices and to create tuna monitoring programs and dolphin-safe labeling.

The dolphin-safe tuna campaign was executed by consumers who directed their purchasing dollars to influence the behavior of companies, but another trend to watch, particularly as the millennial generation comprises a larger percentage of the workforce, is how labor impacts businesses. The boomer generation made a massive impact on how businesses operate and it can be expected that the millennial generation will do the same. Highly skilled workers tend to have a lot of choices in which companies they are willing to work for, and the companies that are able to attract the best talent have a significant advantage over those that don't. Millennials are driven to work for companies that are socially and environmentally conscious. This is a labor decision akin to an a priori ESG investing decision.

Finally, there are also examples of similar actions being taken from the investment angle. For instance, the disinvestment campaign against South African companies of the early 1980s arguably created the pressure that forced the South African government to end apartheid. As millennials begin to control more capital, we may see a trend towards capital flows into ESG companies or away from socially undesirable companies.

In an a priori approach to ESG investing, there is no comparison of investment returns of ESG companies to non-ESG companies, as there is no willingness to invest in non-ESG companies. When I look to the choices that younger generations are making about where and how to work, and what's important to them in the companies they are willing to work for, I expect that at least some of their investment decisions will be made the same way.

When consumers, the labor force and capital align, there is a potential for a boom. We may be seeing the furthest edge of the boom materializing now in the form of the benefit corporation structure and the B Corporation certification. They are essentially the representation of the positive a priori approach for labor, consumers and capital to align. The B Corp standards are too stringent for many businesses to tackle, but their mere existence signals that the investing public may be moving away from the pure utilitarian approach to investing and in the direction of ESG investing.

THE QUANT — RON PICCININI, PH.D., DIRECTOR OF PRODUCT DEVELOPMENT, COVISUM:

According to US SIF: The Forum for Sustainable and Responsible Investment, ESG investing is a fast-growing segment of the investing industry, representing $3 trillion in assets under management. There are over 120 organizations providing ESG ratings, including all the major data providers. Advisors today simply must have an opinion on ESG.

The ESG research started in the 1990's with a simple hypothesis: Companies with weak ESG practices run higher risks of future scandals and thus higher tail risk. Without a doubt, there are good examples of the theory working in practice. Remember the Tobacco Master Settlement Agreement? Enron? The BP Deepwater Horizon oil spill?

What is less clear is whether ESG makes sense financially. The literature is inconclusive at best. The first problem is whether the ESG ratings are indeed of predictive value. With so many different ESG providers and methodologies, it is difficult to study the problem rigorously. Even if the ratings were somewhat in agreement and truly representative of a company's ESG position, they only represent a snapshot in time. The company' ESG policies will evolve over time, so basing a long-term investing decision on today's ratings will not likely work. Constant monitoring is required, which brings us to the third point. ESG research is not free. There are significant monitoring costs associated with running an ESG strategy. Even if ESG investing provides superior risk-adjusted returns, ESG portfolios would have to beat the non-ESG index by an amount above the costs it takes to monitor, optimize and rebalance.

In recent years, ESG has evolved from a pure economic issue to an option for investors to "do good," or at least vote with their dollars for the causes that matter to them. The effectiveness of ESG in this endeavor depends crucially on the difference in costs. If ESG fees are significantly higher, the tradeoff for a rational client comes down to the following:

If an ESG investment returns less after fees than a non-ESG equivalent, the client could choose to earn the returns on the non-ESG portfolio and dedicate the difference to their philanthropic causes of choice, potentially having a much more direct impact and higher utility of the gift (a strategy famously applied by Alfred Nobel).

If ESG investing can clear the cost hurdle, it will likely become the most dominant way to invest of the next decade.

— Related on ThinkAdvisor:

Joe Elsasser, CFP, RHU, REBC developed Social Security Timing software for advisors in 2010. Through Covisum, Joe introduced Tax Clarity in 2016.

Based in Omaha, Nebraska, Joe co-authored "Social Security Essentials: Smart Ways to Help Boost Your Retirement Income."

Renaud "Ron" Piccinini, Ph.D., came from France to America, finally settling in Omaha, Nebraska. He brings extensive experience in building world-class risk systems, supporting tens of billions of dollars in assets to Covisum. Previously, Ron co-founded PrairieSmarts, a software business. Ron wrote his dissertation on what are now known as "Black Swan Events."