At its heart ESG investing is about the responsibility of companies to take accountability for far more than shareholder profit maximisation. Corporate behaviour can and will have profound implications for people and the planet, and this should be a critical element in the decisions businesses make. At times it feels as if this noble aim is lost in the fervour to sell ESG investing; an activity which often relies on unsubstantiated claims about the ability of an ESG approach to boost fund returns. Although lauding a performance advantage might attract investors in the short-term, it is almost certain to undermine the movement long-term. If ESG investing is going to be sustainable the asset management industry needs to change how it talks about it.

Does a Higher ESG Score Lead to Future Outperformance?

Much of the marketing around ESG falls foul of one of the cardinal sins of fund investing. Taking a short, noisy sample and then dubiously extrapolating. The most common approach is to extol the performance of ESG-oriented strategies over the last decade, and then suggest that this is likely to prove a permanent feature.

There are a host of problems with such statements:

– The typical 10/15 year history used is an absurdly short amount of time to draw firm conclusions about the viability of an investment approach. Any random investment strategy – such as picking stocks out of a hat – will enjoy comparable spells of success. Based on this technique, similar comments could have been made about technology in the late 1990s and emerging markets in 2010.

– The time period over which the virtues of companies or strategies with positive ESG credentials are acclaimed is one in which value investing as a style was trounced by quality and growth approaches. It is close to impossible to disentangle returns to ESG investing from what was a broad and sustained market phenomenon of value stocks (a grouping littered with ‘old economy’ names) trailing the wider market.

– Focusing on returns over a relatively brief period (in the context of market history) also falls foul of one of the most dangerous traps in fund investing – the cyclical nature of performance. Our base case should be that strong returns in the recent past are likely to be a prelude to weaker returns in the future. Generally because the market favourites become too expensive, or the environment changes.

– Definitional issues also create challenges for the performance-led arguments that are so often made. Given the understandable inconsistency about what good or bad ESG characteristics really are; it is difficult to make confident claims that there are a stable set of features that have and will deliver superior returns.

Is ESG Investing Lower Risk?

The performance narrative around ESG investing is not solely focused on the returns delivered in the recent past, it also stretches to assertions about it being intrinsically lower risk. The evidence used for this is commonly focused on how companies with positive ESG credentials have fared in periods of market drawdown. The credibility of this case is perhaps even weaker than those based on historic headline returns.

There are two main flaws:

– The sample size used is often ludicrously small. It is not unusual to see the suggestion that because the losses of ESG focused strategies during the March 2020 COVID induced sell-off were less severe than the market it follows that they have permanently lower risk. Leaving aside the dubious nature of conflating temporary drawdowns with risk; we should never make bold prognostications about the future based on one specific market period or event. We can take any style of investing and cherry pick a difficult market backdrop where it fared well. It will tell us nothing about the structural features of that approach.  

– The losses made by any investing style is dependent on myriad of unpredictable factors. The range from the operational features of the companies, the cause of broader market declines, the prevailing economic backdrop and valuations, amongst a host of other elements.  Making forecasts about future risk and losses from specific, narrow instances in the past is dangerous and impossible to robustly substantiate.

When the case is made for ESG investing based on the notion that historic outcomes have been strong and will continue, it not only creates false expectations, but it undermines the entire movement. It makes people invest for the wrong reasons. If the growth in ESG is meant to represent a genuine shift in our approach to investing and become an important lever in our ability to tackle issues such as climate change, then making it about fund performance is exactly the wrong tactic.

We know that investor tolerance for underperforming funds is staggeringly brief. What happens when stocks and funds with positive ESG characteristics start to underperform? Investors are likely to move on to the next outperforming trend, particularly as we told them to focus on the performance prospects.  

It is critical to remember that even if there is a long-term structural return advantage to holding positive ESG tilts in a fund, then it will still suffer prolonged periods of underperformance. Value has one and underperformed the market for the best part of 15 years.

I can entirely understand that strong advocates of ESG investing believe the best way to attract money and attention to the cause is to appeal to the primary driver of fund investor behaviour – past performance. Yet, in this case, taking the path of least resistance means stoking temporary enthusiasm that will be a prelude to a long-term whimper. The use of past performance as a sales tactic is a blight on the industry. It is designed to exploit the worst investor biases and is damaging to long-term outcomes. ESG should be about education not sales.

A major problem at the core of the performance angle for ESG investing is the assumption that believing that something is either good or true, means that you also must believe that it will outperform. If you are sceptical that ESG stocks or funds will outperform, it means that you disregard the entire concept.

This is not how investing works.

At the height of the dot-com craze I could have had a very high level of conviction that returns from internet-based companies would be terrible; this would not have meant that I didn’t believe in the internet.

They are not the same thing. Everything has a price.

How Might an ESG Approach Boost Returns?

Reading this piece so far, you might think that I believe all expectations about the future returns of ESG investing to be spurious. This is not the case. The issue is how the arguments are made. We should never make forward looking assertions about returns based solely on past performance. It is perfectly reasonable, however, to do so if we have a clear rationale as to why something is likely to fare well in the future.

If we have an investment view then we need to state our case.

So, why might ESG investing generate greater long-term gains from here? We can use a very simple model of equity returns to see how it could happen.

Our future equity returns will be driven by a combination of starting valuation + valuation change + growth. Any fundamental view about better performance from ESG investing should be based on one or more of these elements*.

We can take each in-turn:

Starting valuations: It is possible to argue that valuations of companies with positive ESG credentials are priced so that the yield / return we receive from here is more attractive than other areas of the market. This notion leads us directly to one of the main shortcomings in the discussion around the performance attractions of positive ESG stocks – the idea that companies with a lower cost of equity should outperform stocks with a higher cost of equity. This inverts a core principle of investing by stating that lower risk comes with a higher return. If a company manages ESG risks incredibly well, then its cost of financing from equity should be lower, as consequently should be the returns to investors.

Valuation / cost of equity change: Starting valuation is not the end of the story. Strong returns to ESG investing can come from the change in cost of equity / valuation. This can work in two main ways – companies that manage ESG better are rewarded with higher valuations / a lower cost of equity; or companies who manage ESG risks badly suffer from a spiralling cost of equity and major de-ratings. In the latter instance, investors require significantly higher returns to bear the risk of holding equity.

In these scenarios, an ESG investor can generate superior returns by either avoiding the companies with a rising cost of equity or owning those where it is moving in the right direction.

There is, however, a significant issue here with how the industry is reporting ESG. The pace and scale of the movement means that there is a drive for all types of investors to ‘prove’ their ESG mettle, which is typically done by displaying ESG scores or carbon metrics versus a benchmark. Everyone wants to look ‘more ESG’ than the index and peers.

What’s measured is what matters.

This makes no sense. A rational investor would want to be investing in companies with weaker ESG characteristics now but where they think there will be improvements in the future. Why? For two reasons. First, if we are right then we profit from the valuation / cost of equity change as the risk of the business falls. Second, they can use their ownership influence to push for the desired change.

Investing in this type of company means that we might look inferior from a headline ESG perspective. That to many is unpalatable.

The worst possible outcome for ESG investing is that optics matter more than materiality.

Growth: The final element is growth. Earnings growth could be far superior from companies with stronger ESG characteristics, and this is not reflected in current prices. This growth advantage is typically thought of being delivered by companies better positioned to access the opportunities presented in a shifting landscape (almost always related to climate); but it can also be about the reverse. Companies on the wrong side of environmental and societal developments could struggle to deliver earnings growth. An ESG performance edge may arise from avoiding such businesses.  

None of these potential arguments as to why a positive ESG tilt may lead to enhanced performance suggests that there is some ingrained feature that make it an empirically robust factor or risk premia such as value or quality (although ESG and quality are likely correlated). It is simply an expression of an investment view about why positive ESG traits may be currently undervalued and therefore likely outperform in the future. It could apply to the wider ESG complex, or individual companies.

The point here is not to suggest that these arguments are true, but that if anyone makes claims about the potential for improved future returns from ESG-oriented strategies they must explain how this will occur. Even if you disagree vehemently with them, it is surely far better than saying it will work in the future because it has worked for the past 10 years.

Any predictions about the performance potential from ESG investing is an investment view, which needs to be supported and owned like any other.

What is the Real Potential of ESG Investing?

Although I have spent some time attempting to explain the type of contention that must be made to credibly establish a view about the efficacy of ESG investing from a pure performance perspective; I actually think that specific claims about the returns of ESG funds and strategies are incredibly unhelpful. It is often little more than a sales and marketing strategy attempting to exploit the worst performance chasing, behavioural impulses of fund investors. It also blithely ignores the two main prospective ‘return’ benefits of ESG investing.

The two most credible positives of the ESG movement have nothing to do with fund level alpha; they are far broader:

– The shift towards stakeholder capitalism and away from short-term, shareholder return maximisation could have profound benefits for the environment and society. If it assists in slowing temperature rises, reduces biodiversity degradation, or helps limit modern slavery; these are powerful returns, just a different type.     

– Even if you are sceptical about the need or ability of the private sector to drive change in such areas and don’t think such externalities qualify as a type of ‘return’; there is a way that ESG investing may help boost long-term financial returns. If the broad embrace of ESG factors in investing contributes to limiting the rise in global temperature this could improve future asset class performance. Whilst by no means certain, it seems likely that equity returns would be higher in an environment without unchecked warming.

Although these are potentially the most powerful features of ESG investing, they don’t really get as much focus as the fund performance angle. Why is that? Because they don’t sell. If ESG as a movement helps the long-run returns and interests of everyone, that doesn’t help market my fund relative to the competition.

So, instead, we end up making dubious claims about the potential performance persistence of ‘high scoring’ ESG companies, fill our portfolios with businesses exhibiting the best current ESG metrics and dispose of the stragglers (to other investors who might have a different agenda to our own).

This might work in boosting asset flows in the near-term but undercuts the viability of ESG investing in the long-term. Fund investors will lose faith when the inevitable spells of difficult performance arrive, and the potential impact of a positive approach to ESG will be neutered by the desire of asset managers to manage optics and look better right now.   

If we really believe in it, it’s time to change the narrative.

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* We might not have a fundamental view at all and simply see it as a momentum trade. This is perfectly reasonable; we just need to make sure we have a plan for when to get out.

I try to avoid engaging in the folly of making predictions about financial markets, but here is one. Returns over the next decade from most asset classes will be significantly lower than they have been in the past decade. 

It doesn’t take a soothsayer to foresee this. Valuations in many areas are stretched and the expected return from a traditional 60/40 approach is close to historic lows. Of course, this forecast could be wrong; there are scenarios where returns run even hotter from here, but that should be considered a low probability path. 

What’s puzzling about the current backdrop is not that it is one defined by low expected returns – markets are cyclical and these environments will occur – but the investor response to it. We might anticipate a rational reaction to be an increased interest in out of favour areas with more appealing valuations, but that’s not what happens. Instead, we keep buying the most expensive assets. When confronted with lower expected returns we buy more of the asset classes and funds that are likely to have the lowest future returns. 

Rather than consider this activity to be incongruous however, it is exactly what we should expect to see. The structure of the industry, it’s incentives and our own behavioural foibles combine to make it close to inescapable.

What are the main drivers? 

Extrapolation: One of the most damaging investor traits of all and one which Charlie Munger labelled “massively stupid”, is our tendency to extrapolate the past. What has come before will continue. When we persist with buying expensive assets, we ignore the price being paid and simply extrapolate the strong performance into the future. In doing so we ignore every lesson and piece of evidence about capital cycles, valuations and mean reversion. It is why we happily pile our money into thematic ETFs at the peak of stratospheric performance. 

Charlie was right. 

Narratives: Compounding the problem of extrapolation is the power of narratives. Strong past performance is always accompanied by stories to explain and justify it. This creates a virtuous / vicious circle where stellar returns are given a compelling narrative and that narrative further boosts performance. Expensive assets always have great stories. There is nothing investors love more. 

Time Horizons: Most investors operate with time horizons that render valuations irrelevant. By time horizon I don’t mean our ultimate end objective, but the period we care about enough for it to influence our decisions. The latter is typically far shorter than the former. If our patience stretches only to one or two years, then we will rarely notice the importance of the price we pay. Until it is too late. 

Career Risk / Incentives: For professional investors, increasing purchases of expensive assets is about the management of career risk. As money flows into the most richly valued areas they become a dominant feature of benchmarks and the main driver of performance. Almost everyone comes to believe that owning more of these assets is obvious. As this phenomenon persists, we have the choice of either joining the party, or losing assets and our jobs. Our incentives are aligned with buying outperforming, expensive assets and funds even if the evidence suggests it is likely to be of detriment to future returns. 

Emotions: How we feel has an overwhelming impact on the investment decisions we make. Owning expensive assets is, for the most part, anxiety free. They are performing well, everyone else is buying them and the stories provide validation. For cheaper assets the reverse is true; the narratives are bleak, returns have been poor, and owning them means separating ourselves from the crowd.

Much of our investment activity involves doing things that make us feel good in the moment. We can then repent at leisure.

Overconfidence: We are happy to own assets with stretched valuations even if we acknowledge they are prohibitively expensive because we have an exaggerated belief in our ability to time our exit. We will stay invested whilst things are going well and then change course when things turn sour. Whilst this is an attractive idea, the history of market timing suggests the reality is unlikely to be so favourable. 

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Studying investor behaviour is typically about identifying the gaps between what we should do and what we actually do, but sometimes it is more profound than that. Our behaviour is often paradoxical.

Consider the following:

The more extreme the outperformance and rich the valuations of an asset class or fund, the greater the likelihood of disappointing returns in the future.     

And

The more extreme the outperformance and rich the valuations of an asset class or fund, the more attracted investors will be to it.*

Given that most investors are seeking to maximise future returns this inconsistency seems absurd, but it is not. Our instincts and environment make the behaviour both damaging and almost inevitable.**

We shouldn’t be asking why do investors chase performance and buy expensive assets but rather, why wouldn’t they?

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* Momentum investors get a free pass here because – in the simplest terms possible – chasing strong performance trends is their deliberate process.

** The behaviour won’t persist indefinitely – expensive assets don’t keep attracting assets and outperforming – market conditions will change and valuations will matter again. It is just impossible to predict when.

At the pinnacle of its bubble in 1989, a toxic combination of loose monetary policy, rampant loan growth and a spiralling cost of land led the Japanese equity market to trade at close to 100x cycle adjusted earnings. Inevitably this heralded decades of disastrous returns. Between 1990 and the end of 1999 the annualised return from Japanese equities was -4%; over the following decade it managed to fare even worse posting -5% returns per year.[i]

Although investing at such extreme prices seems foolhardy; passive global equity investors would have been increasingly exposed to Japan as the bubble inflated with their allocation hitting 45%. On an EAFE basis the concentration reached 65%:

Does this trait of growing exposure to astronomically priced assets mean a market cap based country allocation is a terrible idea?

No, it is perfectly rational. It just comes with costs and limitations. As with any investment strategy.   

In this binary world our default view is to stridently take one side and vehemently oppose the other. Committed passive investors will claim that an active country allocation is non-sensical given the underwhelming performance history. Active management advocates will argue that any approach that ingrains objectively bad decisions – like allocating half of our assets to staggeringly expensive markets – runs counter to all evidence about what drives long-term returns.

Financial markets are just too noisy and uncertain to take such forthright and singular views. Often two statements can entirely contradict each other whilst both being true.

Take the below examples:

A passive, market cap approach to global equity investing has and will prove to be an effective long-term option for many investors.

and

Investing near half of our equity assets in a market trading at 100x cycle adjusted earnings is an awful strategy.  

If we accept the evidence that buying very expensive assets is a recipe for poor future returns; how is it possible to claim that passive global equity investing can also be a sensible course of action?

There are several valid arguments a passive investor might make:

1) We do not believe there is another method that can consistently put the odds in our favour. It is not enough to say that a market cap, global equity allocation is deeply flawed; we need to have confidence in a robust alternative.

2) The long-run return of global equity markets incorporates incidents of bubbles and manias; they are a known and expected feature that must be withstood.

3) We have no way of telling where a bubble will occur, how far it will rise or when it will crash. Therefore, it is best simply to weather them.

4) It is easy to lament the cost of a bubble or the impact of buying expensive assets in hindsight; it is much more difficult to accept the years of painful underperformance which will come when we reduce our exposure early, yet the momentum continues. The behavioural challenges of an active approach are far too great to bear.

5) Country allocations based on market cap are a reasonable proxy for future earnings on average, despite being wildly inaccurate at times.

None of these arguments suggest that buying extremely expensive assets is prudent, rather they accept the drawbacks of a passive country allocation, whilst believing it to be the best (or least worst) option.

As guilty as active investors are of dismissing the evidence around the efficacy of index funds however, passive investors are equally culpable in rarely acknowledging the shortcomings they suffer. Even committed passive exponents should ask themselves whether there are any scenarios where index exposures become so extreme that they would be willing to go against everything they believe and take active positions away from the benchmark.

What would they do in a repeat of the Japan scenario?

Situations like the one we observed in late 80’s Japan will likely occur again; perhaps we are entering such a phase with the US.

It is easy to be complacent about the rise of US equities to close to 70% of the MSCI World Index. The strong performance that has led to it and the narratives used to rationalise it make extrapolation and justification easy. But we should not ignore that passive investors are becoming progressively more exposed to one of the most richly priced global equity markets.

So, is the US a Japan redux? No. The valuations are nowhere near as extreme (which is not really saying much) and the corporate fundamentals do justify a high US weighting. The FTSE RAFI Developed 1000 index, which weights companies based on factors such as dividends, cash flow and sales has a US equity allocation of c.59%. Not quite 70%, but even if we disregard stretched valuations, the US is still the world’s dominant equity market.

Not being Japan does not mean investors should blindly accept the situation. History would suggest that stretched valuations lead to disappointing returns. It is hard to argue that valuations in the US are not elevated (even relative to other regions).

I have heard passive advocates justify the increasing US weighting by making claims about US exceptionalism and the incredible profitability / market dominance of the tech and consumer names. Whilst this might be a credible case it is conflating an active investment view with the use of index funds.  The correct argument – as mentioned above – is that this type of situation is a known and expected feature of a market cap, global equity allocation; and they believe it to be the best method for capturing long-run global equity returns.  

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There are many awful ways to invest that we should avoid at all costs, but there is also no right way -just a range of reasonable techniques all of which come with advantages and serious drawbacks.  Most investors align themselves with a particular religion (active or passive) and summarily dismiss the other. This is unhelpful and belies the realities of hugely uncertain financial markets with often conflicting evidence.

In simple terms, passive country allocators need to accept that they will buy increasing amounts of punitively expensive assets; whereas active investors (at least those with a valuation discipline) will endure multiple years (maybe decades) of severe underperformance even if they are right in the end.

No approach is perfect, we must pick our poison.

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[i] The Age of Disorder – Deutsche Bank (db.com)