The Future of ESG Investing

Paul Winkler: And a welcome. This is the Investor Coaching Show. Evan, with the magic of technology, joining from his computer. So a lot of stuff to talk about today on the show.

Hey Evan, did you see this thing? There was a — Larry Swedroe had put something out there that I thought it would be a good place to start. It was “The Sobering News for Private ESG Impact Investments.” You happen to see that in Advisor Perspectives at all?

Evan Barnard: I did not, but it sounds like I would agree with it.

PW: Yeah, you would agree with it. Yeah, you totally would agree with it. It just caught my attention just before the show started. I mean, literally five minutes before the show started, I started reading through it and go, “Whoa, whoa, whoa, whoa, whoa, wait a minute. There’s actually academic research to something that we have been talking about here on the show for quite a while.”

There’s actually academic research to back it up now. And something we suspected. Like Evan said, I would probably agree with it. No doubt. And really what it gets to and what really blows my mind is how much of investors’ money …

This is — I guess it falls under the whole headline of: people are sold investments, and they’re sold investments for, many times, all the wrong reasons. And it may be, you know, what we talk about over the next couple of hours, a couple of things that we’ve seen that are just trends that we’re seeing, where people are getting pulled into things that they don’t necessarily know what they’re getting pulled into.

And I ran some really interesting data on two of the biggest fund companies out there and how much of the money in those fund companies is just jammed into one area of the market. And there were some articles that I had actually pulled up where these people are saying, “When you hear people talking about the market crashing and the market’s way overvalued and all of that, well, it’s the area of the market that these fund companies have loaded up on.” And they’re the two biggest ones.

And if you have this Idea in your mind, that fund companies, “Oh, they got big because they do all the right things for investors,” well, you might change your mind after I’m done with this. Because it is sobering, to use a word from this particular article, what is going on right now.

Do ESG Impact Investments Lead to High Returns?

So I’ll tee you up, Evan. Here’s basically what it says: “As predicted by theory,” he says, “increased investor demand” — investor demand. Pick that up. It’s investor demand. What do people want? Not, what should they do? What do they want? — “has resulted in higher returns for public stocks with good environmental, social, and governance.” Okay. So no, not exactly.

It says, “Unfortunately” — what it means is future returns are — what happened in the short run — there was a short-run run-up in the stocks is basically what he’s saying here. So you had a run-up. Why? Not because there were great companies or great companies that you ought to invest in. Those that owned them before were the benefactors of this.

So you think about it: When you’re buying stocks, you’re buying in secondary markets. You’re buying something that has been — you know, you buy an initial public offering. That’s initial.

So in other words, the money goes to the company and the owners of the company. So that’s something that they’re raising capital for the company. Then the secondary market is where you’re buying a stock off of somebody else that already owns it.

Well, think about it. When you have new demand for a certain type of stock … Environmental: think, you know, of companies that are supposed to be doing things that are environmentally sound. Social: in other words, companies that are actually doing things that are socially acceptable or, you know, politically acceptable based on, you know, whichever way the wind’s blowing in any particular day in that area.

EW: Right.

PW: And governance. Yeah, right? And, you know, that has a lot to do with how people spend their money is basically what’s happening.

So what happened here is that these people are demanding to buy these companies. From who? People that already own them. Like, if you have half a brain, and you know somebody that really wants what you own, what are you going to do? You’re going to raise the price. And therefore what happens is the price has gotten very, very high as according to this study in these areas.

Studies Show Future ESG Returns Will Be Lower

And he says new research confirms that basically what’s happening is that future returns — probably going to be significantly lower. Not just lower, but significantly lower than markets in general, because of these incredibly high prices for every dollar of earnings or book value that you actually pay.

And how much money is going here? About one in every $4. It is a huge amount of money.

EB: Wow. I didn’t know it was that big.

PW: Yeah. Yeah. And growing. It’s one out of — you know what it is in Europe? This is nuts. One out of every two dollars in Europe. Is that not something else?

EB: Man.

PW: It is. It’s unbelievable. “The result is that the favored companies will have a lower cost of capital.” What that means in English: that means that they get to use your money for less money. They don’t have to pay you as much to use your money is basically what that’s saying.

And you think, “Oh, wow, this Is really great. This is really great for me and my heirs.” No, probably not.

EB: No.

PW: So Brad Barber — yeah, I know that you recognize that name, Evan — Brad Barber is one of the guys that did the study on this. Adair Morse, Ayako Yasuda — I’m not familiar with those two researchers. They put this research together. It was in the Journal of Financial Economics.

And what they found is that traditional funds had a mean (median) internal rate of return of 11.6%, while impact funds, which are the funds in question — mean (median) rate of return of 3.7%. Ouch. That’s a huge, huge difference.

“The same pattern emerged for value multiples and imputed public … equivalents. After controlling for fund characteristics, the ex-post financial returns earned by impact funds were 4.7 percentage points lower than those earned by traditional VC funds.”

So you think about that. I don’t know what 4% — I didn’t do the calculation, but I know that a 2% difference lowers your accumulation by about, oh, about 40% over a 20-year period. Take 4.7%. I mean, what is that? I don’t even know, Evan.

EB:  More than half, for sure.

PW: It’s huge. Yeah. It’s absolutely huge. And you think about it, what’s — I don’t know, I haven’t looked at this lately — but what’s the premium for stocks right now, you know, versus bonds? If we go back 30 years, it may be 5%, 4%, 5%, something like that.

EB: Yeah.

Why Do Investors Still Choose ESG Investments?

PW: I mean, in other words, that’s how much additional return you get from stocks in general. Why the heck would you own stocks if you’re going to get that much of a lower return? Why even bother doing it? It just boggles the mind.

But why? Do you have a theory about that, Evan? What do you think?

EB: Why people would actually still buy it?

PW: Yeah.

EB: Yeah, I don’t know if this actually ties into answering that specific question, but as you were going through this, I was actually equating it with the GameStop issue a couple months ago. And really what you’re describing with the ESG over-performance in the short term, because there’s this feeding frenzy to buy the stocks, but there’s nothing actually going on in the companies —

PW: Right. To justify it.

EB: It makes the news, you know, when there’s this national manipulation or there’s this sensational story behind it, but really that’s the same thing that’s going on with the ESG investing. But because it’s so slow — and we’ve kind of talked about this in the past, that good news trickles out slowly and bad news happens very quickly and so we pay attention to it. But —

PW: Yeah, very true.

EB: I think it’s kind of the same phenomenon as just, “I want to be able to share at the cocktail party that I have an environmentally friendly portfolio.” And so there’s this rush to get in.

But going forward — I know you don’t like me to say “regressed to the mean” — but at some point, you know, the fundamentals eventually come into play. You have that under-performance, just like the people that got into GameStop at the top. There was no reason for the company to be up that high other than demand for the stock, but not demand for the products of the company.

PW: Yeah. Oh, I think it’s okay to say “regress to the mean,” as long as you don’t say when it’s going to happen. You just have no idea when it’s going to happen.

But, you know, I think — really good point. I mean, you talked about GameStop, and that was — it was a conversation starter. And it’s kind of like Bitcoin. I mean, it’s just a conversation starter. It’s something that, you know, people spend some time talking about.

It gives you something to talk about at the cocktail party or wherever you hang out. Or as you’re driving around town with your Uber, the driver is bringing you around town and telling you about what they think are — there was another thing I saw earlier about the barber shops, how much they’re talking about things that are nonsense investing things.

But, you know, people feel like they’re tuned in. And you probably saw the same thing that I’m talking about since we read the same publications.

Lack of Awareness May Lead to Poor Investments

But they said that traditional funds — huge difference in returns, number one. 2000 onward standard deviation: was there a difference in standard deviation? Amount of risk, in other words? And no, really no difference in risk or the amount of ups and downs and amount of volatility, they said. So it was essentially very, very similar, as they found in this study.

Random utility/willingness-to-pay models: they said investors accepted two to just about four percentage points lower IRRs (internal rates of return, that is) ex ante for impact funds. So, you know, they’re just basically putting up with just being hosed. I mean, just to stick it to the man? I don’t know what the deal is. I really don’t quite get it, but that was —

EB: I think part of it is a lack of awareness, Paul.

PW: It may be.

EB: I mean, you have the article that says that. But if you were to ask those investors, I bet very few of them would say, “Hey, I’m willing to take a 4% hit.” I think they just don’t know that that’s what’s going on.

PW: It may be. But I think they did actually bring that up to people. And they are summarizing their findings. They said, “Our results provide compelling evidence that investors are willing to pay for nonpecuniary characteristics of investments.”

So in English that is that they’re willing to pay for things that don’t make them any money, actually lose the money, just to feel good about themselves. So a lot of it is, you know, really, how do I feel? And of course, you’ll feel a lot worse 20, 30 years down the road when you’re struggling and you’re having to live with your kids, you know, is a way to look at it.

The reality of it is, I mean, look at some of the investment vehicles out there that people are investing in for purposes of being environmentally savvy or being conscious. And the reality of it is these companies are polluting like crazy behind the scenes, and they just don’t even know it. So that’s one of the things.

And then the other thing is that, you know, a lot of times these companies are doing things that are really, really objectionable in other areas that if you brought it up to the investor, they would be probably mortified knowing that the companies they’re investing in and they’re favoring are doing some of these things.

So I think that there’s a lot of that to this. And a lot of younger investors, in particular, are getting pulled in by this. But not only that: older investors are being pulled in without even realizing it.

And I think the reason comes down to when you deal with a lot of these big fund companies. If you look at these big fund companies, who goes to work for these big fund companies in their planning departments and their investing departments but younger people?

So if you have younger people going to work in the big fund company that you happen to be doing business with, a lot of times they’re choosing investments that they favor. And you don’t even have a choice in it because you’ve handed it over, and you have no clue what’s going on underneath the surface.

Are Corporations Just Paying Lip Service to Causes?

I mean, that to me is — I don’t know how many times you do, when you do it, Evan, looking at portfolio analysis work that comes in from various companies. But you probably see what I see, which is a lot of these types of funds sneaking in there and investments sneaking in there and fund companies actually coming …

And I did something about this. I did something on this last week, I guess it was, where I was talking about how these fund companies and investment companies and huge corporations in general, what they’re doing, which is fascinating to me. And you might want to go back and listen to the segment on it if you didn’t hear it.

But what they’re doing is they’re actually playing the game and paying lip service to these types of movements, because it is easier to pay lip service, to sound like you’re on the bandwagon, than to have people pay attention to other things you’re doing that would be objectionable to them.

So let’s say that I decide that I’m not going to brush my teeth for the next week or something like that. And you’re going, “Ew, that’s terrible.” Well, if I decide that I am going to: “Oh, you know what? I’m going to start brushing my teeth. I’m really going to do that.”

And then you’re going to stop paying attention to the fact that I — not the fact, I should rephrase that — or the idea that I’m beating my children or something like that. You start looking good on the outside in order to hide the fact that you’re doing something over there, because people would otherwise start to pay attention to the things that you’re doing inside your household that aren’t so great.

Future Rates of Return Are Impacted By Current Decisions

And that’s exactly what these companies are doing. They’re engaging in things, maybe polluting the atmosphere and polluting the environment, or maybe engaging in tax policy that isn’t so great. Or they’re engaging in things that, from a political standpoint, people would object to, or many would object to.

What they’re doing is they’re saying, “Okay, well, we’re going to be really, really good in here because we know you’re paying attention to this. So we’re going to pay attention to environmental standards, social standards, and governance standards in order to have you not pay attention to the other hand over here that’s doing something that you’d be objecting to.”

And that’s literally what they found in this study that I was referring to on a previous show. So a lot of it’s that. A lot of these companies, investment companies, are doing this because they know it’s what you want. And it’s, “Don’t watch the other hand. Watch the one I’m trying to get you to pay attention to.”

And it was involving — I was actually talking a little bit about how the smartest investors and the smartest people tend to be the most easily fooled is really what it gets down to. Because they know what you’re paying attention to, and they’re really one step ahead of you.

But what happens is intelligent people tend to pay so much attention to details, details, details, (and one of them would be this ESG) details — “Hey, what are you guys investing? And where are you putting money? What are you putting my money in?” — that they miss the big picture that they’re actually doing things that would be really objectionable.

And now we’re seeing rates of return could be hugely impacted by these decisions as time goes on, and as we’ve seen, already have been, according to the research out of these universities.

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