Why ESG Investing is Bad: Poor Performance and More

May 5, 2023

If you don’t know what ESG investing is or don’t understand it, don’t feel bad. Most people do not, including many people who are currently participating in ESG investing.

What IS ESG Investing?

The acronym ESG stands for Environmental, Social and Governance. As a group of words or as a phrase, they do not seem to have any meaning. From an investment perspective, ESG investing is applying a layer of non-financial factors when analyzing the value and investment merits of a company and its stock.

Specifically, it is a filter in which companies are analyzed based on their supposed impact on the climate, their policies toward diversity and inclusion and how their governance or management reflects their adherence to these directives. Whether or not this filter is the only one used when selecting investments or if it is layered on top of an actual financial performance analysis depends on how strident the ESG mandate is. This type of investing creates some significant problems and lacks a certain amount of common sense.

In this article, we will outline four major problems with “ESG” or sustainable investing.

Problem #1

The first problem with ESG arises when you try to determine which company is “ethical” enough or “green enough”. What constitutes an ESG company varies massively from one interpretation to the next. Virtually every investment dealer, bank, or professional association has their own interpretation of what constitutes ESG investing.

If you are familiar with Eric Weinstein’s four quadrant model, you will understand that corporations have virtually no true moral values and are instead rent seekers in the virtue signalling game. Accordingly, you will understand why corporate interpretations of ESG investing are necessarily very malleable.

Lobby groups and non-profits, on the other hand, have very hard-line interpretations of what ESG investing is – and will stop at nothing to force the adoption of their standard. But beyond these immutable facts, you can imagine the difficulty in trying to select ESG standards and eligible companies.

Is an electric car manufacturer ESG?

An electric car draws massive power from electrical grids – many of these grids are powered by coal or nuclear power, each of which has its own environmental concerns. The cars are also filled with plastic, and their batteries are sourced from minerals often mined in ways that reportedly exploit or even kill workers.

Do you still think electric cars are good for the environment? Recently, Standard & Poor’s removed Tesla from its ESG 500 index, while oil giant Exxon remained. How does an oil company pass an ESG filter? With some filters even trying to prevent animals from being eaten, virtually any social cause you could imagine could be a part of an ESG filter. Quite simply, there is no standard ESG standard – because creating a common standard is both impossible to agree upon from one person to the next and from one organization to the next. And as we shall see – it’s also bad for business!

electric car chargers in a row

Problem #2

The second problem arises when ESG advocates or ESG investors try to determine the relative weight or importance of the “ESG score” when selecting companies for investment. Most financial institutions have created their own scoring system to evaluate a company’s adherence to ESG values and dictates.

As you might imagine, companies involved in petroleum and natural gas, metals and mining, alcohol, confectionary, etcetera all score very badly. But not only do scoring systems and filters vary widely from one organization to another – there is a significant difference between institutions on how any of these filters are applied in the process of stock selection. Should the ESG score comprise 100% of the information analyzed to select a stock? Should it be 50%? or 20%? Should it be 5% Or 0%? Many ESG advocates argue that it should be the only filter applied to stock selection.

Let’s hypothetically look at what a 100% perfect ESG company would look like. Let’s imagine that a public company decides to only hire people based solely on the group they identify with and not at all based on their merit, abilities, and experience as they had always done previously.

Then, they decide that the board of directors and senior management need to be selected and chosen based on these same ESG parameters. Let’s imagine that this new management group rules that it will only distribute its products to customers willing to walk or cycle to its manufacturing locations to pick up their products, and those customers must be willing to sign a pledge never to transport their product by a petroleum engine.

Additionally, the new management group decides to turn 50% of any profits over to the UN. Their ESG Score would be exceptional. But ask yourself – does that make any intellectual or economic sense at all? Would you buy that stock? Where does this hypothetical company sit on the market-driven, merit-based continuum which has created the wealth, health and prosperity of the 21st century?

Problem #3

This third problem should you concern you more than numbers 1 and 2. And that is the significant inherent volatility and risk of adhering to an ESG agenda or mandate. A significant positive correlation in portfolios is a negative thing. This occurs when we have a portfolio of similar positions, which all have a tendency to rise and fall based on the same economic inputs – all at the same time.

A typical example of this would be a portfolio of Canadian resource stocks. The resulting volatility decreases the long-term performance because losses disproportionately negatively impact long-term performance. If you lose 50% in a portfolio – then you need to gain 100% to get back to zero. This is exactly why we at McIver Capital Management go a long way to specifically build negatively correlated portfolios.

As we have already seen, there is a large disparity between various ESG filters, but they all do essentially the same thing. They artificially restrict the universe of available positions that a potential portfolio could own. And the stocks which typically are able to pass through these filters – are all very similar to one another. The subsequent result of this is that all the potential positions for an ESG portfolio tend to be positively correlated with one another. We know that this will increase volatility and decrease performance.

ESG Portfolio Performance Example

Let’s look at a real-world example of this, The ARK Innovation ETF. This is likely the most well-known and popular of many actively traded ETFs holding highly concentrated – and heavily ESG-filtered positions. This ETF was the darling of the investment world just as the Covid panic washed over the world. It was the undisputed champion of investment genius. It was discussed as the future of investing. Until it wasn’t.

When the covid stimulus cheques began drying up, and the speculation mania began to die down, this massively popular ETF began to fall.

If you had put $10 million into this rockstar-managed ETF in January 2021 – you would have lost $7 million by June 2022. Remember: if you lose 50% – you need to gain 100% just to get back to zero. This means that even if you can find a 10% annual return, it will take 7 years just to get to zero. A loss of 70% will take more than 12 years to make back – and again – That is only if you can find a steady 10% annualized return.

ARK ETF Performance

That is a long time to wait just to get a 0% rate of return. These losses are devastating. Unbelievably, this same company just launched a new ETF based 100% on ESG metrics and 0% on financial metrics, called the Transparency ETF. This Virtue Signaling ETF has already lost a whopping 34% of its value as of this writing.

The more stringent the ESG rules are, the more positive correlations there are between the individual positions in the portfolio, and therefore, the more concentrated the portfolio is. This results in more volatility. Effectively, the more stringent the ESG agenda or mandate – the greater likelihood of poorer long-term performance!

Related: The Death of the 60/40 Portfolio

The Hypocrisy of ESG Investing.

In order to avoid the type of volatility in those ESG ETF’s we see organizations such as Standard and Poor’s kicking Tesla out of its ESG Index while adding EXXON. They are likely trying to add balance and negative correlation to the Index. Which makes sense from an investment perspective. But then, are they really “ESG” investing?  The hypocrisy is plain to see.

Problem #4

That Social Imperative of ESG has been so great that many Banks and Investment Dealers have been accused of “greenwashing”, which is effectively pretending that non-ESG investment funds and portfolios somehow represent ESG investing to make them more acceptable. Recently, one major European Bank was raided by 50 police officers based upon the accusation and suspicion that the bank fraudulently claimed that half of their investment funds were ESG. Following this, the CEO of the investment division resigned.

There is increasing pressure put on people and organizations in the Investment Industry to push ESG products. Consequently, there is increasing pressure put on clients to invest under these dictates and restrictions as well. The question investors must ask themselves is, what’s in it for me?

As soon as you are approached by an ESG investment advisor or told that the investment choices being provided to you by an institution are all “ESG compliant,” – then that person or that organization is indicating that they have already compromised the universe of potential investments down to a narrow set of investment choices which fit inside of a social construct – or political belief set. In short, they have an agenda with your capital.

At McIver Capital Management, our philosophy is completely different. We are not here to impose our values upon you.  As fiduciaries, we have no other agenda than to maximize your long-term portfolio growth.

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