In this episode of 'Coffee with Brendan,' Brendan delves into the increasingly controversial concept of ESG (Environmental, Social, Governance) investing, providing an overview and comparing ESG investing strategies versus traditional investing strategies.
What is ESG Investing?
ESG Principles: Environmental, Social, Governance
Comparing ESG Investing Strategies with Traditional Strategies
Pros and Cons
Analysis of ESG Funds Performance
Hi, and welcome to another edition of Coffee with Brendan. Today's episode is one that, if you haven't heard about it yet, it's definitely something you're going to hear about as we get closer and closer to the 2024 presidential election. And that is ESG investing or what some conservative talk shows and conservative candidates like, like to reference it as as “woke investing.”
And so, what is ESG Investing? I will talk about that today, some of the pros, some of the cons, and then ultimately, look at one metric that actually shows the performance of ESG-type investing strategies versus non-ESG, or more traditional type investing strategies.
So why are we even talking about it? Well, first and foremost, 90% of all companies that make up the S&P 500 publish something as it pertains to ESG–they publish some kind of ESG report. And in terms of growing, they've–these types of investments have grown from about $5 billion in 2018 to 20 times that in 2022. So over a five-year period, the growth rate has been about 20 times there in 2022, over $100 billion dollars went into ESG-type funds. And it was in 2022 that there was a turning point with ESG investing. And that's when Ron DeSantis tried to put together a coalition of 18 other states that tried to ban ESG scores from being considered when making investment decisions, specifically with state-run pensions and things like that.
And so that's pretty much a background of where, where we've come and why this is important. But let me spend a couple of minutes talking about what actually is ESG investing because I think we have to start there. So let's jump into that. Let me just open up my screen here and get into that piece. So ESG investing combines three principles: environmental, social, and governance.
Environmental is exactly as you expect, pollution, carbon footprint, carbon emissions, things like that. So you get a score for your environmental impact as a company.
Social is, you know, customer satisfaction, data privacy, data protection and privacy, gender, and diversity, which is one of the reasons why folks get really upset about this is that, you know, they feel like gender diversity doesn't add anything to the whether or not investment or a company should be invested in community relations, employee engagement, human rights, and labor standards.
And then you have your governance and board composition is probably one of the hot topics as to why, you know, again, opponents of ESG investing really take an issue with, you know, why does it matter? You know, there are too many men or too many white people or too many whatever, on the board of directors of a specific company. Another piece is executive compensation. Does the CEO make this much, and the lowest person make this much? Or is it closer, that's something that ESG folks pay attention to.
So when a third party comes in and measures a company's ESG score, what they're basing that off of are these three main principles.
Now, turning, turning the page for a moment, there are different ways of scoring. So the first way and probably the least, or only put it differently, the most consistent with traditional investing is what's called negative screening. Still, what a negative screen ESG strategy is looking at is they still want performance. First and foremost, they don't really measure and say they don't care. They want performance first and foremost. And what they're doing is screening out certain companies that are in the weapons, tobacco, alcohol, gambling, adult entertainment, and oftentimes carbon or the oil companies and things like that. That is probably the closest to traditional, so if we're going on a scale the first one is traditional investing doesn't take any of these things into consideration. The next step up the latter is negative screening which is pretty much traditional investing, adding negative of screens, getting rid of some of those companies that are the, quote, bad companies.
Then we get into the ESG integration. That's probably what we're talking about here is actually not just taking out those companies that don't, don't have high ESG scores, but actually rewarding those that do. And so that's where you're still looking for performance, first and foremost. But what–and we'll talk about this when we get to the pros and cons–what supporters of ESG investing would say is those companies that have high ESG scores tend to have good stock performance and good profitability as well.
Then we get into shareholder advocacy. So that's taking it one step further and using your proxy votes to dictate the future direction of a company. So not just investing in the company, but also proactively using your proxy votes to actually direct the company one way or the other.
And then this last one here, the impact and community investing. That is probably where a lot of the people feel like the opponents of ESG investing probably put a lot of their eggs in this is pretty much saying that the ESG impact is more important than the performance that people are willing to sacrifice rates of return for diversity, inclusion, all those types of things that are hot buttons for in the political arena that we're in right now. And so what we're talking about today, is that more than ESG integration, as opposed to this impacting community investing, that does take it one step further. But what we're still talking about is ESG integration, and does the inclusion of adding ESG scores into an investing decision actually impact the future performance of the investment.
And so, let's get into the pros and cons right now of ESG investing. So the pros, if we're if we look at this is that for those companies that tend to score higher on ESG, they typically have above-average risk control and compliance standards. And so that helps them and again, this is what the argument would be for adding ESG scores into investing decisions that would reduce a company's exposure to things like accidents, fraud, lawsuits, boycotts. You know, we saw that with some of the companies, you know, some of the more liberal people stayed away from things like Goya, for instance, because the Goya president was seen with Trump or supported Trump or something, you know, where people boycotted him because of that. And that led to profits going down because of it in other adverse events.
So having a high ESG score, the supporters of adding ESG would say that it reduces your risk to things like that. But the other piece, and you know, this is one that I think has merit, like it or not, younger workers who are coming out of universities, they care about this stuff, they want to work for companies that they feel are, are our values based in purpose, purposeful, and how they spend their money and treat the world treat the planet. And it makes up their boards of directors and things like that. And so, by not having a high ESG score, you run the risk that you're not going to be able to attract the highest level of talent. And so I think that all of the different positive points of including ESG is the most important with this.
So let's flip the page and look at some of the cons, and the cons really amount to one, I'd say two things. The primary thing is what Ron DeSantis would say, gender inclusion, diversity, all that kind of stuff. Doesn't matter. It's not going to it's it's a distraction. And it's just it's, it's having people focus on the wrong things, and allocate resources, time, and energy to something that's not going to drive company performance.
So that's the first one and probably the primary one, but the second one, which, which, again, I'll throw my editorial comment in here, I think does have some merit, which is that ESG scores are not consistent. There was a study by MIT that showed that of six major ESG ratings firms, they found that the correlation of their scores is only 61%. Compare that to the three credit agencies that weigh in on your creditworthiness, and they have a 99% correlation. So we're looking at a 61% correlation among six ESG rating firms compared to 99% for the credit firms in the United States. So that is an issue. And what supporters would say is that they acknowledge that, and they say, Listen, we stipulate that that's an issue. However, the scores are getting better, and in these firms are coming together with different and coming to an agreement on what's important and what's not important.
So ultimately, the big question that's on everyone's mind is, does it make a difference? And can we point to anything that actually says that, you know, adding ESG scores in or not adding ESG scores in does or does not impact performance.
And so, let's take a look at a couple of the bigger or the most popular ESG funds that are out there. And so I'm looking at iShares, iShares, or exchange-traded funds. And what the iShares here are, are the S&P 500. So the iShares core S&P 500, compared to the iShares, MSCI KLD 400, which is it follows one of the most commonly tracked social index, is socially responsible indices. And you can see, and maybe it can't say, but long story short, the average annual rates of return are actually very close. If we were to compare these and actually put them on top of one another, then what you're looking at is–give me one second, I'm going to share the screen. What you're looking at is something that looks like this, where the blue line—again, I know this is very small—but the blue line is showing where the S&P 500 outperforms the KLD 400. And you can see that at different times, they're very close, you know, if you look at that, this here, you know, this IBD versus DSI, you can see that over time, they're very close, where there have been times where the S&P 500, which is the IBD has underperformed, the KLD 400. But then, recently, especially in 2022, it's actually caught up some, and the furthest that we have here, the furthest one that I can pull is January 10, 23. And cumulatively, between those two, you're looking at 249% positive for the S&P 500. And the KLD 400 is about 251%. So almost exactly the same over since 2007.
So again, take it for what it's worth, I will say, you know, and again, I have to be fair here, the KLD 400 is more of the negative screen, where they're taking, you know, all the different companies that are represented in screening out those alcohol, tobacco firearms. And coming up with that, it's not as much the ESG, where they're actually rewarding companies and overweighting towards the companies that are actually doing well from an ESG standpoint.
So I think I gave - I hope - let me put it differently. I hope I gave a balanced view on this. More than happy to talk about it more with you on a one-on-one basis. But at least this is a primer on ESG and why it's important, and why it's going to become a hot topic for the 2024 election. So be well. Do good. And we'll see you next time. Bye bye.
Brendan is the Managing Director for Waymark Wealth Management. He has extensive experience in comprehensive wealth management. His focus includes retirement planning, behavioral finance, investment portfolio construction, education funding, insurance & risk management, taxes, charitable giving, and estate planning. Brendan has an ability to take clients' complex visions and distill them down to simple action plans, helping them move from where they are today to where they want to be tomorrow.
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