ESG investing (avoiding investments with “bad” Environmental, Social, or Governance aspects) is becoming more popular but has been around a long time. The approach was previously known as SRI (Socially Responsible Investing) or colloquially as avoiding “sin stocks”.
A quick note on terminology first. If I talk about a “good” or “bad” investment, it isn’t clear whether I mean in the moral sense or in the risk-adjusted-return sense, so I am going to use good/bad to refer to the expected risk-adjusted returns and virtuous/evil to refer to moral qualities. I’m also going to avoid scare quotes even though in many (perhaps most) cases reasonable people could disagree about the virtuousness or evilness of an investment. Of course, when I say “evil investor” I merely mean one that invests in companies that fail the ESG screen – not that they are literally evil people. With that out of the way …
There are a few issues with ESG investing, some of which may not be obvious:
- There is no universally, or even widely, accepted definition of an evil company. One person’s “arms dealer” is another person’s “defense contractor.” So, it isn’t clear which investments should be avoided. Google’s motto was “don’t be evil” yet they are frequently considered evil by at least some people.
- ESG investments are screened, not weighted. In other words, if it is evil it gets zero investment. If it is “not-evil” (which is different from virtuous) it gets full investment. So, rationally, companies should be a little evil – little enough not to be screened out, but as much as is consistent with high returns otherwise.
- Evil investors will get higher returns. As virtuous investors avoid evil investments the price declines, which is simply another way of saying the expected return rises.
- There is a temptation to think that by investing in virtuous companies the returns will be higher – virtuous investors can have their cake and eat it too. It is easy to imagine that evil companies will have higher costs or lower sales (or both) because of their practices. But if that is true, they are not just evil, they are stupid. An evil businessman might not particularly care about the environment or women’s rights, but he is unlikely to actually reduce earnings to try to harm either! Thus, the argument that virtuous stocks are good investments, can ignore the ESG part. Unless, somehow, you believe the market is not pricing the expected returns of evil investments correctly. This seems unlikely. My guess is that management errs more frequently the other direction – a CEO would actually give up some shareholder return to be seen as virtuous and this is actually an agency cost problem, not a benefit.
If you want to make the world a better place, it is far more efficient and effective to do it through direct contributions of time or money to charities and causes you support than to try to indirectly help through your investment portfolio.