Two Things to Know About ESG with Michael DelGiorno

Paul Winkler: Welcome to “The Investor Coaching Show.” Paul Winkler talking about money and investing. Helping make the unclear clear, that is always my aim.

What I shoot for is understanding. Not that you have to get all of this stuff and know everything that we know, but having some understanding increases peace of mind. It takes away worry when it comes to investing.

What is ESG?

The question was how do you avoid some of the ESG? Is this just politics getting in the way of your investment portfolio? How can it be avoided if this is something to be avoided?

Michael DelGiorno: What is ESG, environmental social governance? Has somebody ingeniously tapped into all the capital of our 401(k)s for their political agenda and should it be stopped?

PW: Yeah, environmental social governance, that is something that is the hot topic right now in the investing industry. It’s a hot topic for other reasons other than what you may think.

Mutual fund companies like it, because they can charge more for their services to screen investments so they can charge higher fees. Because it’s been a race to the bottom regarding fees in the past several years.

Well, this gives them the ability to go and increase those fees and offset that, number one. Number two, there’s a really big drive with younger people to do well with their money.

Young people want to help the environment, want to help the world, want to save.

They don’t recognize that when you invest in the stock market, you’re just investing in companies. You’re buying those stocks off of somebody else that already owns them. You’re not necessarily helping those companies, so then it gets out of whack.

But the Department of Labor basically had this rule that said that employers couldn’t consider ESG and be a fiduciary. If you do this, you’re not necessarily keeping the best interest of your investors first, so they didn’t allow it.

Well, then they went and reversed that. They said, “Well, okay, we’re going to let you do that after all.”

I have been railing against this for years. Because ESG, if you look at funds that are ESG compliant, the returns have been less than stellar. They’ve been underperforming.

You could see why the Department of Labor before would’ve said it wasn’t in people’s best interests. Then for them to cave, I can’t believe they did. Yeah, so that’s the gist of it.

Supporting Companies with Your Money

MD: Let me restate for everybody. The concern is not limited to but is primarily not wanting their money to support companies that do things they don’t believe in.

But I mean, a simple solution would’ve been a button you can press. Do you want ESG or not?

There’s a reason from a fiduciary investment and return perspective, fee perspective, and an industry perspective to be concerned about this. 

As much as your money supports companies that might believe things you don’t, let alone return.

PW: Well, and it’s even more complicated than that because if they basically say, “Hey, you’ve got to consider this or we’re going to put this in your portfolio.” This can raise the cost of capital as we call it. They raise the cost of using your money for non-compliant companies.

Think about the oil industry, they’re going to have to pay more and that’s where you hear people yelling and screaming. They’re going to have to pay more to use your money.

But here’s the interesting thing that you don’t think about it as an investor. If you can avoid this and you do that by reading prospectuses, and making sure that it isn’t a focus of the funds that you’re investing in.

I know they’re not going to read a prospectus, but the advisor should be. The advisor should be and the problem is that you’ve got younger investment advisors that get sucked into this as well because it sells.

Here’s what’s really super interesting about this. If you have raised the cost of using people’s money when you have this type of a rule in place, you’ll actually have lower returns for companies that do comply, because they don’t have to pay as much to use your money.

Chasing Companies

What you want as an investor, you want higher returns. If you are investing in companies that are complying, they don’t have to pay as much, which actually again goes against your desires and needs, which is really interesting.

MD: Well, that’s what I was going to ask you. On the one hand you say, “Well, it’s not really supporting these companies with new money, you’re buying existing stocks.” But if the focus is on those, it’s got to be giving them more capital because they’re getting more preferential sales. But what you’re saying is because of what it does to the value, it’s actually hurting those companies rather than helping them, ultimately.

PW: Yes, supply and demand. You’ve got a ton of money chasing CDs, let’s say. What happens to the interest rates on CDs? They go down.

If you’ve got a ton of money chasing companies that are complying, what happens to the return expectation? It goes down. It’s really simple if you think about it that way.

It is more important to make sure as an investor that you don’t fall into chasing companies.

All GOP senators, Manchin included, are challenging Biden’s ESG, climate-investment rule. They always say climate but it’s environment, social, and governance. We should probably talk about all three of those, but it sounds like somebody woke our 401(k)s without telling us about it.

MD: How concerned should we be and what actions can we take, just so that’s clear?

Yeah. I wouldn’t be concerned if you’re not falling for it, is really what it gets down to. When I invest, I don’t look for funds that comply with this because they tend to be higher-cost funds.

You Can Avoid Certain Funds

MD: Well, that’s the difference between you managing money in a 401(k), though with a 401(k) you don’t have any control, right?

PW: Yeah. But the 401(k)s, you’re going to find, Michael, that they have that as a selection, as a choice. Typically, it will be spelled out that this is a socially conscious fund or something like that will be in there. You can just avoid it. I mean, it’s pretty easy.

MD: Okay, so that was my initial question. It ought to be quick if I want that, if I believe in that and do that. If I want to make less money in order to feel like I’m making a difference in the climate, go ahead.

But I shouldn’t have to have my money go to that without me knowing. You’re saying I’d have to click on that to get it.

PW: Well, you’ll have funds even in funds that aren’t going after that agenda that will be in those companies. I want to make sure you’re clear that you’ll still be investing in companies that consider themselves to be socially and environmentally conscious and so on and so forth.

Here is the part that is really interesting regarding that. Now, let’s say that a company does engage in all these things that are environmentally conscious, socially conscious. That raises their costs as a company to operate.

That’s another reason that it can actually hurt returns in the future, but here’s the thing to keep in mind. If those companies are doing that, that information is already built into their stock prices.

It may be counterintuitive that you need to own stocks to protect yourself from this, but it’s true.

It’s not something you can go around and start to anti-select against. But here’s the thing: let’s say that they force some of these technologies. It can force companies to produce things that are in compliance and that raises their costs, but it can also raise their profits. What do you get as an owner of a company? You get the rights to the profits.

Yeah, and it can be inflationary. Who’s going to pay for all the additional costs that are being borne by companies? The consumer. Which is called what? Inflation.

The Political Aspects

It may be very counterintuitive, but that’s exactly what you’ve got to do as an investor. Because if the dollar goes down in value or if you have to pay more for stuff, who’s charging more? Companies.

What do you own on your own stocks? The companies. I think that the thing that’s really important is for investors not to get sidetracked by this.

MD: ESG, environment, social, governance, it’s a big political debate. If it’s a big coup on all your capital in your 401(k)s to funnel towards their political agendas, it may be much to do about nothing because it’s simply in the end, isn’t sustainable and doesn’t work?

PW: It may not. The political aspects of this are fascinating and they’re going to change with every election.

The political aspects of ESG will change with every election.

A Department of Labor thing that I talked about there where they actually said, “Nah, this isn’t people’s best interest. It doesn’t work against the fiduciary standard. You’re not keeping people’s best interest first, if you’re going and pushing this type of investing on people.”

Then of course, reverse course. They turn around and they say, “No, this is okay. We’re going to let you do that.”

This is something that’s being fought right now, this whole idea of actually politicizing, as a lot of people like to call it. You can see the point, it’s politicizing.

There’s also people who think that it’s just the way of the future. We need to make sure that we do this. This is how we save the world. Isn’t it funny how we are always trying to save things?

The idea behind ESG and this is where it’s so confusing. Because the idea is how do we avoid this completely in our investment portfolios and you can’t.

You cannot avoid this because there are companies out there that are doing, even companies that are not ESG compliant that are trying to do things that are considered that.

Compliance and Demand

You can even take the oil companies and they’re trying to go to… And you can argue all day long that electric vehicles don’t fall into that, but they are doing things like pursuing possibly hydrogen. Pursuing and that would be hydrogen might be used, or nuclear fusion might be used to power electric vehicles.

You might still have electric vehicles, it’s just where does the power source come from? Is it fossil fuels or is it coal or what actually makes the electricity? I mean, you get back all the way to where it starts and where it originates. Is that where the energy is going to come from?

You have some of these companies that people say, “Nope, they’re not compliant at all.” And yet they’re trying to do things in that way.

Well, why would they try to do that? It’s just simply because if there’s a demand for it, if a younger generation, that’s what they want and they are bent on going that direction, maybe we’re not ready for it.

But they’re going to go that direction just so that they don’t get left behind. Like Motorola inventing the cell phone and then not pursuing it enough, where companies like Apple and Nokia came in and ate their lunch.

Nobody wants to be left behind.

What happens when you invest, you might have well, 500 companies in large U.S. stocks. 2,400 companies, let’s say small U.S. stocks. Another 2,000 that are small value companies and 800 companies that are international large companies. Another 4,000 would be small international, so you have all these different companies in there.

How do you weed out the companies that are compliant versus non-compliant? That’s how these fund companies are making money.

They’re saying, “Hey, we’ll do that work for you.” Well, that’s a lot of work and they can charge for it and it’s a way of making more money.

What happens when they spend all of that time doing that? Expenses increase. They’re buying companies that are popular amongst younger investors. What’s happening is the company prices will be higher compared to the earnings.

The Cost of Being Ahead of the Game

People are going, “Hey, these companies, they’re ahead of the game on this particular thing or the direction that we seem to be heading as a world.” Since they’re ahead of the game, they will pay a premium price.

Or people that currently own the stock sit there and go, “I own XYZ company that is ESG compliant and somebody wants to buy it from me.” There’s some good promise maybe for this company because they’re on the cutting edge of where we seem to be going, whether we like it or not.

Hence, I’m not going to let it go for a pittance or a small amount. I’m going to charge a premium price for that when I sell it.” They sell it for a premium price, and the price is high compared to the earnings.

When the price is high compared to the earnings, the future expected return should be lower, because they don’t have to pay much to use your money as I talked about. The cost of capital is lower. They don’t have to pay as much because they’re not giving up as much in earnings for every dollar you pay for those earnings.

When I invest, I want funds that are as broad as possible. 

When I look at the holdings, the number of holdings in a mutual fund, if it’s investing in large blend stocks, I want to make sure it’s at least 500 companies.

As a matter of fact, indexing works really well for large U.S. stocks. Now, when I index S&P 500, large U.S. stocks, I’m not ESG compliant. Because there are some companies in there that would not comply with people’s standards as far as environmental and social.

Now, governance is a little bit more complicated. I’m not going to get into that, but it has a lot to do with how the board works and how information flows and things like that, and it’s just way too complicated to get into here.

Indexing

But if we’re looking at small companies, I don’t want a small cap fund, I want something that holds those 2,400. They can become mid-caps, medium-size companies, small companies become medium cap and they need to be moved out and hence the index can range in size.

Now indexing is a way of doing this. It is problematic in that it’s going to overweight bigger companies, lower expected return. I could index, now what I choose to do personally for our practice, we use an index type of thing, but we remove things that are objectionable.

I might have something that’s capturing small company stocks, but I’m removing real estate investment trusts and limited partnerships and IPOs and things that I don’t want in the portfolio.

I’m also not weighing it based on the size of the companies. I’m not putting more money in big companies which have a lower expected return, which is what indexes do.

With owning the entire market, I can look at the prospectus and say, “Hey, are they trying to be ESG compliant? How are they rated by Morningstar as ESG compliant?”

If they’re really high rated, it may tell you that they’re trying to be really high rated. If they have ESG in the name like social consciousness or something like that, there may be a good sign for you right there that they’re trying to do that because they’re putting it in the name.

Shared information is typically for marketing reasons.

There are young people out there and there’s some older people, but a lot of younger people want to do good with their money. They think that they’re doing good by owning companies that are doing good.

And they don’t recognize that they’re actually ending up, as we’ve seen through history, with lower returns because these companies are higher priced. They have a lower expected return going forward.

They could probably do better with their money making their own choices.

Want to talk with us directly?

Schedule a call here.

*Advisory services offered through Paul Winkler, Inc. (‘PWI’), an investment advisor registered with the State of Tennessee. PWI does not provide tax or legal advice: please consult your tax or legal advisor regarding your particular situation. This information is provided for informational purposes only and should not be construed to be a solicitation for the purchase of sale of any securities. Information we provide on our website, and in our publications and social media, does not constitute a solicitation or offer to sell securities or investment advisory services, or a solicitation to buy or an offer to sell a security to any person in any jurisdiction where such offer, solicitation, purchase, or sale would be unlawful under the securities laws of such jurisdiction.