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So, ESG Investing Isn't Perfect. That Won't Stop It.

So, ESG Investing Isn't Perfect. That Won't Stop It.

| January 23, 2022

Writing for the Wall Street Journal (Why the Sustainable Investment Craze Is Flawed), author James McIntosh states that "Despite claims to the contrary, these investments don’t do much to make the world a better place."

So, a colleague suggested that I rebut this article. But upon reading it, I don't think Mr. McIntosh's article is actually that negative towards ESG investing. Like any investment approach, ESG investing can be flawed if the execution is poor or misunderstood. Yet throughout his article, the author identifies ways that ESG investing is good, and how companies who enact ESG-centric policies benefit. We'll look at a few examples later in this article.

That said, I must take issue with the author's choice of two sustainable indexes that purport to show that the "jury is still out" on sustainable investment performance. It is not, and no serious author should use one year of performance as evidence of anything. One index did well and the other did not over this short period.

While no strategy can outperform each year, a recent study by Morningstar shows that a broad index of sustainability leaders has outperformed traditional equity indexes for the past five years. Investors find a five-year track record more compelling in assessing the acumen of fund managers.  Why not here, too?

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Even with solid performance, ESG investing is surely not perfect. I often tell my clients that trading your fill-in-the-name "polluting" company for my so-called "cleaner" one does nothing to make the World a cleaner place. Making that trade is what is known as increasing "alignment" with your values, and there's nothing wrong with that, even if it doesn't improve the World. It changed your world.

Not investing in what you find offensive is the right of every investor. Logically, each investor should take care to understand the portfolio ramifications of excluding so many sectors that the portfolio becomes riskier and narrower. But investor choice is, as they say, "what makes a market".

To address my colleague's suggestion (to make a rebuttal), I need to ask a question: Could it be that the author actually making a positive case for ESG investing? Let's take a look.

In stating that "someone has to take a loss somewhere if fossil fuels are going to be left in the ground rather than extracted and sold", he makes a strong case for avoiding the "stranded-asset" risk that is inherent in all companies whose valuations are partly determined by the value of their fossil fuel reserves. That sounds like an ESG advocate. Check.

He agrees that "if companies treat the environment, workers, suppliers and customers better, it will be better for business", but then asserts that there are scant opportunities to continue to improve. In a capitalist system, companies never stop trying to our pace their competitors. To argue that this somehow doesn't apply to ESG factors is simply lazy logic. Again, check.

If a company's ESG efforts "should only help the stock price if it also raises revenue or reduces other costs", then why not show the evidence that some companies, through better management, are able to earn higher margins and returns on capital? There are ample opportunities to show how some companies are having less trouble finding workers in the current environment. Might they be just better places to work? Tell me again why treating workers with respect is somehow not aligned with a higher stock price? Check, check.

Without rebutting each point the author makes, I'll close with another point where we agree. Focusing solely on "alignment" runs the risk of missing the most important aspect of impact investing: Making an actual impact. To accomplish this, investors can pursue alignment with their values while also investing with an "engagement" mentality, focusing on changing corporate behavior over time. And they can seek "additionality" in their investments -- i.e., investing in those ventures that provide something additional to the World as a result of that new capital being employed.

From constructing solar farms to supporting microfinance to financing ventures in impactful technology, investors who meet the financial criteria for investing in the private markets can make sure that their dollars are being deployed in a manner that delivers additionality and makes a positive impact.

In short then, ESG investing is a three-legged stool. Alignment is important, as long as you don't overestimate the impact that your dollars are making. Engagement will help you increase your impact via the public markets. And seeking to add something new and impactful to the world (your additionality) rounds out what makes ESG and sustainable investing more than a fad or a suspicious trend -- instead, making it a sea change in how investing is done.