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As a small investor I resent very much the use of so-called “ESG scores” to guide investment decisions on my behalf. ESG stands for “Environmental, Social, and Governance” criteria for rating companies. These scores or grades are developed and assigned by various firms (Refinitiv, CSRHub, and many others) to public companies. The scores are then marketed to financial institutions. While ESGs from various sources are not yet standardized, a public company can attempt to improve its ESG scoring through adoption of environmental goals such as “zero” carbon, diversity and inclusion initiatives, and (less objectionably) by enhancing its systems and processes to ensure protection of shareholder and other interests.
Who Uses ESGs?
An investment fund, for example, might target firms with high ESG scores as a way of appealing to progressive investors. Or an institutional investor like a pension fund might wish to invest in high ESG stocks in order to avoid riling “woke” activist investors, thus keeping the hounds at bay. This is nothing new: many corporations engage in various kinds of defensive actions, which amount to modern day “selling of indulgences”.
An aggregate ESG score can be calculated for a fund or portfolio of stocks by weighting individual holdings by market value. And of course, an ESG score can be calculated for YOUR portfolio. As a “service” to clients, Merrill Lynch plans to do just that.
My first reaction was to give my ML financial advisor an earful. Of course, ML’s presumed objective is to guide you to make “better” investment decisions. However, I do not wish to reward firms with capital based on their “social” positioning, nor do I wish to encourage exercises in “wokeness”. I simply want to supply capital based on a firm’s business fundamentals.
My advisor was more than sympathetic, and I believe he’s sincere. The problem is that corporate wokeness is so ubiquitous that it becomes difficult to invest in equities at all without accepting some of it and just holding your nose. That goes for virtually all ETFs and index funds.
ESGs Are Not Consumer Scores
I’m obviously unhappy about this as a Merrill account holder, and also as a financial economist and a libertarian. But first, a few words about what is not happening, at least not yet. A number of conservative commentators (see here, and here) have described this as an assignment of “social credit scores” to consumers based on their individual or household behavior, much as the Chinese government now grades people on the quality of their citizenship. These conservative voices have reacted to ESG scores as if they incorporate information on your energy usage, for example, to grade you along the environmental dimension. That is not the case, though ESGs can be used to grade the stocks you own. And yes, that is rather Orwellian!
One day, if present trends continue, banks might have access to our energy usage through affiliations with utilities, smart car companies, and various data aggregators. And who knows? They might also use information on your political contributions and subscriptions to grade you on your social “wokeness”, but only if they have access to payment records. Traditional credit information will be used as it is now, to grade you on financial discipline, but your “consumer ESG” might be folded into credit approval decisions, for example, or any number of other decisions that affect your way of life. But except for credit scoring, none of this is happening today. All the consumer information outside of traditional credit scoring data is too scattered and incomplete. So far, ESGs are confined to evaluating companies, funds, and perhaps your portfolio.
ESGs and Returns
ESGs get plenty of favorable coverage from the financial press and even from academics. This post from The Motley Fool from 2019 demonstrates the kind of praise often heaped upon ESGs. Sure, firms who cater to various cultural trends will be rewarded if they convince interested buyers they do it well, whatever it is. That includes delivering goods and services that appeal in some way to environmental consciousness or social justice concerns. So I don’t doubt for a moment that money can be made in the effort. Still, there are several difficulties in quantitatively assessing the value of ESG scores for investment purposes.
First, ESG inputs, calculations, and weights are often proprietary, so you don’t get to see exactly how the sausage is stuffed. On that point, it’s worth noting that much of the information used for ESG’s is rather ad hoc, not universally disclosed, or qualitative. Thus, the applicability (and reliability) of these scores to the universe of stocks is questionable.
Second, inputs to ESGs represent a mix of elements with positive and negative firm-level effects. I already mentioned that ESGs reward good governance on behalf of shareholders. The environmental component is almost surely correlated with lines of business that qualify for government subsidies. More generally, it might reflect conservation of certain materials having a favorable impact on costs. And attempts to measure diversity might extract legitimately positive signals from the employment of highly productive individuals, many of whom have come from distant shores. So ESG scores almost certainly have a few solidly useful components for investors.
The proprietary nature of ESG calculations also raises the question of whether they can be engineered to produce a more positive association with returns. There’s no doubt that they can, but I’m not sure it can be confirmed one way or the other for a particular ESG variant.
Like cultural or consumer trends, investment trends can feed off themselves for a time. If there are enough “woke” investors, ESGs might well feed an unvirtuous cycle of stock purchases in which returns become positively correlated with wokeness. My thinking is that such a divorce from business fundamentals will eventually take its toll on returns, especially when economic or other conditions present challenges, but that’s not the answer you’ll get from many stock pickers and investment pundits.
Remember also that while a particular ESG might be positively correlated with returns, that does not make it the best or even a good tool for evaluating stocks. In fact, it might not even rank well relative to traditional metrics.
Finally, there is the question of causality. There are both innocent and pernicious reasons why certain profitable firms are able to spend exorbitantly on initiatives that coincidentally enhance their ESGs. More on that below.
Social and Economic Rot
Most of the “green” initiatives undertaken by large corporations are good mainly for virtue signaling or to collect public subsidies. They are often wasteful in a pure economic sense, meaning they create more waste and other costs than their environmental benefits. The same is true of social justice and diversity initiatives, which can be perversely racist in their effects and undermine the rule of law. And acts on behalf of “stakeholders” often sacrifice shareholders’ interests unnecessarily.
There are many ways in which firms engaging in wasteful activities can survive profitably, at least for a time. Monopoly power is one way, of course. Large companies often develop a symbiosis with regulators which hampers smaller competitors. This is traditional corporatism in action, along with the “too big to fail” regime. And again, sheer growth in demand for new technologies or networking potential can hide a lot of warts. Hot opportunities sometimes leave growing companies awash in cash, some of which will be burned in wasteful endeavors.
Ultimately, we must recognize that the best contribution any producer can make to society is to create value for shareholders and customers by doing what it does well. But to see how far the corporate world has gone in the other direction, keep this in mind: any company supporting a sprawling HR department, pervasive diversity efforts, “sustainability” initiatives, and preoccupations with “stakeholder” outreach is distracted from its raison d’etre, its purpose as a business enterprise to produce something of value. It is probably captive to certain outside interests who have essentially commandeered management’s attention and shareholders’ resources. And this is evidence of rot.
My reference to “portfolio rot” reflects my conviction is that it is a mistake to dilute investment objectives by rewarding virtue signals. They are usually economically wasteful, though sometimes they might be rewarded via government industrial policy, regulators, and the good graces of activists. But ultimately, this waste will degrade the economy, undermine social cohesion, and devalue assets generally.
What Can We Do?
Despite the grim implications of widespread ESG scoring, there are a few things you can do. First, simply avoid any funds that extol progressive activism, whether based on ESGs or along any dimension. If you invest in individual stocks, you can avoid the worst corporate offenders. Here is one guide that lists some of the “woke-most” companies by industry, and it provides links to more detailed reviews. I gave my advisor a list of firms from which I wanted to permanently divest, including Bank of America, which owns Merrill! I also listed various firms that are owned and operated by Chinese interests because I am repulsed by the Chinese regime’s human rights violations.
If you have the time, you can do a little more research before voting your proxies. That goes for shareholder, board, or management proposals as well as electing board members. You are very unlikely to swing the vote, but it might send a useful signal. I recently voted against a Unilever green initiative. I also researched each of the candidates for board seats, voting against a few based on their political, social and environmental positions and activities. Good information can be hard to get, however, so I abstained from a few others. This kind of thing is time consuming and I’m not sure I’m eager to do very much of it.
You can also support organizations like the American Conservative Union, which is “taking a stand against the increasingly divisive and partisan activism by public corporations and organizations that are caving to ‘woke’ pressure.” And there is Stop Corporate Tyranny, which is “a one-stop shop for educational resources exposing the Left’s nearly completed takeover of corporate America, along with resources and tools for everyday Americans to fight back against the Left’s woke and censoring mob in the corporate lane.”
People can make it harder for social credit scoring to enter the consumer realm by protecting their privacy. There will be obstacles, however, as sellers offer certain benefits and apply “nudges” to obtain their customers’ data, and it is often shared with other sellers. Sadly, one day those who guard their privacy most closely might find themselves punished in the normal course of trade due to their “thin” social credit files. There are many dark aspects to a world with social credit scoring!
Conservative Social Scoring?
There are at least two ETFs available that utilize conservative “social scoring systems” in picking stocks: EGIS and LYFE. Both are sponsored by 2ndVote Funds. EGIS has as its stated theme to invest in stocks which receive a favorable rating in support of the Second Amendment right to bear arms and/or in the interest of border security. LYFE seeks to meet its long-term return objectives in stocks with a favorable rating on the pro-life agenda. Both have reasonable expense ratios, as those things go. Unfortunately, my advisor says Merrill won’t allow those funds to be purchased until they have close to a full year of experience.
Are these two ETFs really so special? Are they really just marketing gimmicks? After all, I noticed that EGIS has Goldman Sachs in its top 10 holdings. While Goldman might not be the worst of its peers in terms of wokeness, it has stooped to some politically-motivated “cancel capers”. Moreover, do I really want to mix my investment objectives with my social preferences? Leftist investors are doing it, so countering might be well-advised if you can afford the risk of diluting your returns. My heart says yes, but my investor brain isn’t sure.
When it comes to investing, I’d prefer absolute neutrality with to respect social goals, other than the social goals inherent in the creation of value for customers and shareholders. Any emphasis on ESG scores is objectionable, but it’s a regrettable fact that we have to live with to some extent. If “social scoring” is unavoidable, then perhaps the themes adopted by 2ndVote Funds are worth trying as part of an investment approach. After all, given my personal blacklist of woke corporations, I’ve already succumbed to the temptation to invest based on social goals. And I feel pretty good about it. Unfortunately, it might mean I’ll sacrifice return and witness the continued descent of western society into a woke hellscape.