So Are ESG Investments Lousy, or Not?

Governor Ron DeSantis and other GOP pols seek to stamp out sustainability-minded investing, charging that it delivers poor results.

Reported by Larry Light

Art by James Yang


Are sustainable investments bad investments?

This question is at the heart of a fast-growing controversy involving state pension programs, other public funds and asset managers. Some GOP-dominated states are taking a hard line against environmental, social and governance investing, claiming it displaces economic fundamentals and thus shortchanges fund beneficiaries.

Like so much else in a divided nation, ESG, aka sustainable, investing has become politically controversial. Numerous Republican governors and officials have banned ESG-oriented investments from their public pension funds, or condemned asset managers that they say shun fossil fuel stocks. Their opponents protest that ESG is the best idea long-term because it steers investments away from problem-laden companies—and renders good returns both now and in the future.

The emphasis in this debate is on the E part of the acronym, with a little bit on the S, in particular racial sensitivity. The G segment, which seeks to improve corporate governance, gets the least attention—and when it does, the concern is often about proxy votes related to sustainability.

Who is right about ESG investment performance? So far, the evidence is thin that ESG stocks and other assets are inferior investments. Whether they are superior ones is not yet apparent. “The empirical evidence is somewhat muddled, resulting in very diverse opinions across both practitioners and academics,” says Joshua Lichtenstein, a partner at the law firm Ropes & Gray, who is an expert on the ESG investing fracas.

Performance Puzzle

To be sure, there is considerable doubt that ESG investments can deliver, and not just among Republican politicians. The annual institutional investors study by Schroders Investment Management found that 58% of U.S. institutional investors said “performance concerns were a hinderance for sustainable investing.”

Some studies have found that ESG fails to generate superior results. Let’s use retail mutual funds as a representative for the entire ESG investing field. The ESG funds don’t outpace non-ESG ones, per an  article three years ago in the Journal of Finance by two University of Chicago professors, Samuel Hartzmark and Abigail Sussman, which covers several years before the 2019 study.  

Other studies disagree. Over the recent past, which covers a roaring bull market, ESG fund returns look pretty decent: 80% have posted market-beating returns during the past three years globally, although they have lagged in 2022, a study by Investment Metrics found. That has a lot to do with the trajectory of technology stocks—the mainstay of ESG portfolios, as they emit relatively little greenhouse gas—which did spectacularly until this year.

Indeed, 2022 has been unkind to many sustainable retail funds, because tech stocks have fallen off their perch. Meanwhile, energy, the bane of climate worriers, has done well in the market as oil and gas prices have climbed amid shortages induced by the Ukraine war, among other causes.

A study from research firm Morningstar found that 65% of sustainable funds score at the bottom ranking for equity, fixed income and other categories this year. For example, one highly regarded ESG fund, Calvert Equity I, lost 17.7% for the year through last Thursday, worse than the broad-market S&P 500’s 15.9% loss.

Maybe the disparate conclusions stem from the difficulty of pinning down a large and growing investment sector, when the definition of an ESG security is vague and in flux.

In a bid to overcome that problem, Northern Trust Asset Management did a study that breaks down stocks according to their sustainability and quality scores. The study concluded that the “best quality” ESG stocks outpace the rest. NTAM designated ESG stocks by examining items such as their companies’ carbon emissions and diversity. Then it culled quality stocks by screening for characteristics including high profitability and strong balance sheets.

Companies with both high ESG and quality scores “do better overall,” comments Mike Hunstad, the firm’s CIO for global equities. Among the Russell 1000, over five years through mid-June 2022, high-quality ESG stocks clocked a 12.7% annual return, besting high-quality non-ESG shares’ 11%. But sustainability was no savior for stocks with poor fundamentals. Low-quality ESG stocks trailed their non-ESG counterparts, 3.1% to 7.1%.

Outside of public securities, there are private equity ESG efforts that proponents say deliver good returns, around 8% annually, and benefit communities. These harness capital to finance small businesses in so-called opportunity zones, meaning distressed areas that lack jobs. These vehicles allow tax breaks for investors in PE limited  partnerships that plug money into such areas. “Good things are happening” that are under Wall Street’s radar, says Reid Thomas, chief revenue officer of JTC Group, which provides services for these funds.

Backlash Against ESG

States including Oklahoma, West Virginia and Kentucky have passed legislation this year barring state funds from investing in companies that engage in “boycotts” of the oil and gas industry. Florida is seeking to do the same.

Glenn Hegar, the Republican state comptroller of Texas, last month accused BlackRock and eight other finance firms of shunning the energy industry; a Texas law limits its municipalities and other government bodies from doing business with companies that boycott energy outfits. In July, West Virginia said it wouldn’t award state banking contracts to five firms it considers anti-fossil fuel: JPMorgan, Wells Fargo, Goldman Sachs, Morgan Stanley and BlackRock. 

Last month, 19 Republican state attorneys general accused asset manager BlackRock of using its economic power to “force the phase-out of fossil fuels, increase energy prices, drive inflation and weaken the national security of the United States.” And they charged that the financial giant uses ESG priorities while investing state pension money.

“Our states will not idly stand for our pensioners’ retirements to be sacrificed for BlackRock’s climate agenda,” wrote the group, which includes AGs from the big oil-, gas- or coal-producing states, such as Texas, Oklahoma and Louisiana.  

Two weeks ago, Florida Governor Ron DeSantis eliminated ESG strategies for the State Board of Administration, which oversees the state’s retirement funds. As the Florida SBA’s chief trustee, he pushed through a resolution specifying that investments “must be based only on pecuniary factors.”

Implicit in the Republican assault on ESG is that sustainability-themed investing will do poorly. “I think you’re going to see a really strong groundswell of people wanting to stand up to protect the people in these pension systems from not being roadkill in somebody’s ideological agenda,” DeSantis said.

Asked to supply evidence that ESG investing does badly, a DeSantis spokesman replied: “The governor’s assertion is common sense—if investment decisions are being made using any factors other than the fiduciary and pecuniary interest of the beneficiary, then the best financial decisions aren’t being made.”

ESG Believers  

The asset managers targeted by the GOP, such as BlackRock, respond that they do not refuse to invest in fossil fuels, and indeed have large sums invested in oil and gas companies. They admit that they offer mutual funds and other products that follow ESG precepts, but insist these are to meet customer demand—and, they argue, to deprive  investors from such choices is not in anyone’s interest.

BlackRock said in a statement responding to Texas Comptroller Hegar that it “does not boycott fossil fuels” and the fact that it has invested “over $100 billion in Texas energy companies on behalf of our clients proves that.” The statement also says that “elected and appointed public officials have a duty to act in the best interests of the people they serve. Politicizing state pension funds, restricting access to investments, and impacting the financial returns of retirees is not consistent with that duty.”

Meanwhile, in blue-state America, views of fossil fuel investing range from divesting to a more selective approach. The New York Common Retirement Fund announced in late 2020 that it would divest all oil and gas company stocks (the pension plan named Exxon Mobil and Chevron), as well as those of fossil fuel service outfits (it named Schlumberger) and pipeline providers (Kinder Morgan). In 2021, Maine passed legislation blocking investment by the state’s Public Employees Retirement System in the 200 largest publicly traded fossil fuel companies.

Then there’s the more nuanced strategy. The California State Teachers’ Retirement System, for instance, prefers “engagement” with oil and gas companies—meaning electing board members who can make those companies more climate-friendly. It spearheaded a successful proxy effort in 2021 to place ESG-minded members on Exxon Mobil’s board.

To continue such efforts, the pension fund has retained investments in energy stocks. CalSTRS’ March analysis of its portfolio said its exposure to the fossil fuel industry totaled $4.1 billion, which is a little over 1% of its current $312 billion portfolio. Earlier this year, CalSTRS successfully opposed a bill in the legislature that aimed to require it and other state pension plans to divest its fossil fuel investments.

This isn’t to say that the fund will not curtail its fossil fuel holdings. Last week, CalSTRS announced a strategy to strengthen its commitment to net-zero emissions, which involved trimming investments in greenhouse gas emitters. But it may not unload all its Exxon stock; CalSTRS CIO Chris Ailman indicated that its main stock-divesting focus would be on industries that burn oil and gas, such as utilities and transportation, rather than on energy extractors.

The Measurement Question

Beyond all that lies the issue of how best to measure ESG. Methods vary widely on what things to gauge and how to weight them in a portfolio. With that in mind, Massachusetts Institute of Technology’s Sloan School and several financial firms, such as AQR Capital Management, have launched an effort to codify how to appraise ESG—called, appropriately enough, the Aggregate Confusion Project.

One criticism of ESG investing is that, when it shows good returns, this might be because of temporary factors that have an outsize impact. Such superior returns are  often driven by climate-news “shocks,” declared Robert Stambaugh, a professor at the University of Pennsylvania’s Wharton School, and two other academics, in a recent paper. The reference is apparently to a spell of severe drought or destructive hurricanes. The professors expressed uncertainty as to whether any future ESG outperformance can be assumed.

Of course, with climate-oriented investing now a partisan issue, a welter of claims and counter-claims has appeared. To pro-ESG folks, science is on their side, hence the opposition is just blowing smoke to confuse people.

Anti-ESG politicians appear to be convincing the public that a “false equivalence” exists between their stance and the sustainability advocates, contended Witold Henisz, director of Wharton’s ESG Initiative, in a recent article in the Knowledge Wharton periodical. He wrote that “ideological opposition [is] cynically seeking a wedge issue for upcoming political campaigns — and, so far, it appears to be working.”

Whatever the outcome of the current debate over ESG-related bans and the like, the climate change question is not going away. Says CalSTRS’s Ailman, “It will be with us for the next 50 years.”

Related Stories:

DeSantis and Allies Bar Florida SBA from ESG Investing

19 GOP Attorneys General Slam BlackRock Over ESG Investments

Allocators Still Skeptical That ESG Can Deliver Good Returns

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CalSTRS, Chris Ailman, ESG, Florida SBA, Republican, retail mutual funds, Ron DeSantis, S&P 500, Stocks, sustainable, technology stocks,