ESG investing is wishful thinking
ESG investing is wishful thinking
You can't outsource moral choice and you even shouldn't try.
In this issue:
What is ESG investing?
No one can do the right thing for you
What makes an investment 'good'?
What are ESG funds actually selling?
How to be a good investor
What is ESG investing?
Environmental, social & governance (ESG) investing is a catch-all term for "socially responsible" or "ethical" investing: choosing to invest in companies and projects with a track record of good environmental stewardship, ethical labor practices or any other values-based considerations. There is no formal definition of what does (and does not) constitute an ESG investment and no governing body that controls who is allowed to consider or market themselves as ESG.
Of course anyone can decide to invest (or not) in something for ethical reasons and we don’t need a special name for it. ESG investing does not mean investing while trying to be a good person. Rather the term ESG emerged to describe a new class of investment funds that promises to offer "ethical" investing as a service. Researching and understanding the moral character of companies is hard — why not hire a professional to handle it for you?
ESG investing is the well-meaning but naive belief that economic outcomes are predictable and moral choices are obvious. In reality we can barely guess at the consequences of our investments, let alone agree on their moral character. No one has a crystal ball for the market or an ethical compass. Selling the promise of "socially responsible" investing is dishonest. Buying it is naive.
To be clear, I don’t mean that ethical investing itself is naive. Rational investors are well within their rights to choose investments based on whatever criteria make sense to them, financial, ethical or aesthetic. What is naive is outsourcing responsibility for those preferences to the market. You can’t pay someone to do the right thing for you. The only moral choices are the ones we make ourselves.
No one can do the right thing for you
Even without ethical considerations its already difficult to pay for good investment advice because of the principal-agent problem. It is hard to outsource meaningful decisions to expert advisors because you don’t know if their advice they are offering is serving them or you. Did your investment advisor recommend the best fund for your portfolio or the one that pays them the highest fees for referrals?
Modern financial markets approach this problem with a financial carrot and a legal stick. Financial advisors are usually rewarded for good advice with compensation that scales with performance, like a hedge fund charge a percentage of any profits they made on behalf of their investors. Many financial advisors also have legal liability if they knowingly give you bad advice — at least those who have fiduciary responsibility, the legal obligation to act in your client’s financial best interests.
Even with these protections there is a great, yawning gap between good financial advice (things that turned out in retrospect to be profitable) and illegally bad financial advice (things that the agent knows for sure are a bad idea in advance). It would be nice if it was also illegal to sell bad investing advice but a lot of people would end up going to jail so instead it is only illegal to sell bad investing advice on purpose. Lots of mediocre financial advisors underperform and keep their jobs. Investing is hard!
It is also entirely possible to give bad ESG investing advice / run an underperforming ESG fund, but it is harder to know for sure when it happens. For ESG investors to evaluate whether they received good investment advice they need to know both how their investments performed and how morally influential they were. Their total return is part financial and part non-financial.1
ESG funds are marketed to investors as though portfolios exist along a spectrum from profitable to ethical — but the reality is more like a spectrum from accountable to unaccountable. Profit is mercenary but it is also knowable (at least in retrospect). There is no equivalent way to measure moral influence, which means there is no way for investors to distinguish between ESG investments that overperform and those that underperform on their moral mandate.
Marketing an investment as ESG is like labeling a product "all natural" — it sounds nice but it doesn’t actually mean anything in practice. There is no implicit promise and no standard for quality that can be met or failed. Concrete/specific claims like 'this fund only holds solar power companies' or 'this food is vegetarian' can be rewarded by the market or enforced by government action, but subjective claims like 'this food is delicious' or 'this investment is socially responsible' are impossible to evaluate. ESG investing has all the same principal-agent problems of traditional investing but without any of the tools for accountability.
The market creates competition over things that are measurable. But ESG investors have no way to measure the "moral performance" of their investments — they were relying on expert help to identify morally worthy investments in the first place. Assessing the non-financial performance of an ESG investment is like asking a chef if their food as delicious. There is no way to know if they believe it and even if they do it still might not be true for you.
If a traditional investment fund is overcharging or underperforming other funds can compete by offering better returns or lower fees, but the moral returns of an ESG fund are immeasurable and incomparable so there is no way to know if another ESG fund could offer better moral returns at a cheaper rate. The more investors rely on expert advisors the more vulnerable they are to their expert advice. In other words, ESG funds don’t compete to create moral impact, they compete to create the impression of moral impact. ESG investing is just a kind of moral marketing.
On examination even the promise of ESG investing does not make sense, because morality is not a one-size-fits-all universal truth. Moral choice is deeply nuanced and personal. Outsourcing your morality to the market is like paying an expert to decide what songs you like. Each of us has to decide what socially responsible investing means for ourselves.
What makes an investment 'good'?
In theory an ESG fund promises to track some portion of the market but over-invest in the "good" investments in the sector and under invest in any "bad" investments. That sounds fine but is profoundly difficult to execute in practice because companies (just like people) don’t cleanly map to "good" or "bad." Imagine for example we are an ESG fund deciding what to do with a natural gas mine in our portfolio.
Most ESG investors are concerned about climate change and natural gas is a fossil fuel, so perhaps we should sell the mine. On the other hand natural gas is relatively clean compared to other fossil fuels like coal, which is the other dominant source of energy in the region, so perhaps we should keep it. The company has terrible diversity numbers, so we should probably sell it. Or perhaps we should keep it and as owners demand better representation?
Also, the diversity numbers aren’t great but they are above average for the region so maybe it is diverse, relatively speaking? Unfortunately the region in question is in Russia, so perhaps we should sell anyway out of solidarity with Ukraine. But of course we would be selling it to Russians, so perhaps we shouldn’t. Maybe the moral value of just closing the mine outright is worth the financial cost — or maybe it would just open the way for less ethical competitors to fill the resulting market gap.
The idea that an expert with a spreadsheet could calculate the moral truth and sell you the answer is absurd. The questions above are not math problems, they are value judgments. No one can make them for you.
What are ESG funds actually selling?
As the example of our hypothetical natural gas mine hopefully makes obvious, moral choices are profoundly difficult and money does not offer us any shortcuts. Hiring experts to make our moral choices for us is just layering the problem one step deeper. It’s just as difficult to evaluate the moral performance of an ESG fund as it would have been to make the moral choices for yourself. ESG funds are not selling moral expertise because anyone who needs moral expertise has no way of knowing whether or not moral expertise was actually provided. So what are they selling?
In some cases ESG funds are selling a concrete, well-defined set of criteria that they think many investors will happen to agree are ethically desirable, like a fund that exclusively tracks solar energy companies. Those funds might use fuzzy marketing but they are ultimately selling an objective product subject to ordinary market competition. Other funds can offer the same targeting criteria at a lower rate, so the market can reward the most efficient providers of whatever products investors demand. Investments like this are totally fine. They aren’t really ESG funds since they don’t apply any moral judgement in their mandate — they’re just traditional funds that recognize the power of fashionable labeling.
The more troubling cases are ESG funds that market themselves as an all-purpose vehicle for ethical investing. Those funds are essentially pledging to do your moral homework for you — which is a fundamentally dishonest promise to make. The actual product that they sell is moral complacency — the false impression that you don’t need to think very carefully to be a good person. It is the modern equivalent of buying indulgences from the church.
The marketplace is like a self-assembling vending machine. It will rebuild itself to sell you any product you ask for but it can’t retain the moral intent of your purchase because it has no moral character of its own. If what you ask for is measurable (cheap, durable, high performing) the market will rise to meet your measurements — but if what you ask for can’t be measured (cool, delicious, beautiful) the market will sell you marketing instead. Ethics can’t be measured. Buying investments that advertise themselves as moral is just a way of buying advertising.
How to be a good investor
It would be nice if being an ethical investor was as simple as being willing to tolerate slightly lower returns, but unfortunately it’s not that easy. Identifying ethical investments by being open to lower returns is like identifying medicinal herbs by being open to bitter tastes. It might be helpful but it’s definitely not sufficient.
For most investors making individual ethical assessments of specific assets is just as unreasonable as making individual financial predictions for specific assets. Almost no one should be actively trading their portfolio, whether they measure their returns in dollars or hedons. Anyone who isn’t a dedicated savant is better off investing in index funds than making targeted investments, both financially and ethically.
In fact, since the moral consequences of investment are even more difficult to predict ethically minded investors should be even more reluctant to deviate from the market index. Every individual trade an investor makes is adding to their portfolio risk. There are a lot more ways to underperform the market than to overperform and including ethical consequences in your returns only makes it harder.
The uncomfortable truth is that most people should not be making targeted moral investments for the same reason that they should not be making targeted financial investments: they aren’t qualified to do so. Instead of relying on the market to be moral on our behalf, we are better off being realistic about the practical limits of our ability to be moral investors.
If we acknowledge that true moral investing takes time, effort and expertise I think it is fairly obvious that most people should save their moral energy for other parts of their life where they have better understanding and more influence. ESG investing is based on the false promise that you can do the right thing without thinking very hard. It’s not true and you shouldn’t believe it.
Just put your money in ordinary investments and focus on being a good person.
Technically you might also be an ESG investor because you think a certain category of ethical behavior is more profitable in the long run. Perhaps you think good labor practices correspond with good risk management, or perhaps you think fossil fuel will be outlawed soon and so are bad investments today. In that case though you just are an opinionated investor, no different from one that prefers tech stocks or precious metals. Your investment thesis just sounds better at dinner parties.