ESG underperformance will be the strategy’s eventual undoing. We have discussed the many problems with ESG investing in previous posts.
In those previous articles, we primarily focused on the excessive expense ratios charged for funds that are essentially duplicates of low costs benchmark indexes. To wit: With ESG now the rage, the “demand” drives product development. However, there is also an understanding of why large asset managers have embraced the strategy so readily – higher fees. Yes, you too can own an ESG fund that is almost three times as expensive as the S&P 500 index fund, all for the sake of “feeling good about yourself.”
While ESG investing gets promoted as a way for individuals to “invest with their principals", such has been a windfall marketing scheme by Wall Street firms.
Been There, Done That
In the late ’90s, Wall Street moved to limit investing in “sin” stocks such as gambling, tobacco, etc. Just as it was then, investors initially jumped on board, but when returns failed to outperform the benchmark index, that “fad” died. The same occurs today as investors who want to be “woke” are demanding products that make them feel good to purchase. However, just as we have witnessed with the various ARKK ETFs, while you may “feel good” about owning “disruptive” companies, that changes quickly when those companies are no longer performing. See chart below.
The same occurred with the allure of cryptocurrencies as “laser-eyed” zealots retreated into the abyss following a crushing decline. See next chart.
Such is inherently the issue facing ESG funds. Investors might be willing to pay higher expense ratios as long as they earn higher returns. However, ultimately they will focus on ESG underperformance, which will likely become more prevalent as funds that previously underperformed and lost assets simply rebranded themselves.
“Epic greenwashing is everywhere: Out of 253 funds that switched to an ESG focus in 2020 in the US, 87 per cent of them rebranded by adding words such as ‘sustainable’ or “ESG” or ‘green’ or ‘climate’ to their names. None changed their stock or bond holdings at that point.” Source: Eco-Business
Unsurprisingly, the buzzword of “investing scam” is gaining more traction. “The Securities and Exchange Commission said this month that it was planning on cracking down on misleading ESG claims. New rules ‘would specify disclosures to be made by investment funds when they mention terms like ‘ESG,’ ‘low-carbon’, or ‘sustainable’ in their names. Regulators are also looking at ‘ESG funds marketing and how environmental, social and governance is incorporated into investing along with these funds voting at companies’ annual meetings.” Source: Bloomberg
Not surprisingly, outflows are rising as ESG underperformance continues, as can be seen in the next chart.
Inflation Could Kill ESG
Another problem for the ESG “investing scam” is inflation. If you believe inflation is here to stay, ESG underperformance will continue, too. While 2022 has been so far a year of “inflation” concerns by the Fed, the underperformance of ESG relative to the energy sector has been quite profound.
“As Deutsche Bank’s Jim Reid puts it, ‘one of the side effects of the hawkish pivot from the Fed in 2022, that continued this week’ is that it could finally crack the facade of ESG and make January a catastrophic month for ESG investors; this is shown in Reid’s Chart of the Day which lays out the 1-month rolling difference between S&P 500 Energy sector returns and the NASDAQ.” Source: ZeroHedge
However, that underperformance didn’t just start in January of 2022. In 2021 the surge in money supply led to increasing rates of inflationary pressures. As we showed previously, inflation is currently running well above the Fed’s target inflation rate.
Not surprisingly, that inflationary surge showed up at the gasoline pump as oil prices rocketed higher. As a consequence, and of no real surprise, investors dumped ESG funds in favor of “dirty" energy. It is also worth noting that ESG funds also underperformed the SPY tracking index.
ESG investing may be great for headlines, but it is all about performance when it comes to investors.