ESG investing has gone from a booming theme to the scourge of investors everywhere. Backlash around its ability to outperform and confusion surrounding what qualifies a stock as ESG has turned a lot of investors off to the idea altogether. Mark Neuman, the Founder and CIO of Constrained Capital, has created an index that targets those names excluded from the ESG indexes which attempts to outperform the market based on the reverse ESG effect. He joins the ETF Think Tank to discuss the problems and future of ESG.
Neuman views ESG stocks as those that are under specific financial constraints. His research found that stocks that were under these constraints tended to underperform. His conclusion was that virtue comes at a price and ESG comes at the expense of lower returns. As a result, he began to identify non-ESG stocks with the idea that if ESG underperformed, the opposite could outperform. He started with the traditional sin stocks. Fossil fuel and nuclear energy were identified later. Eventually, his company’s ESG Orphans Index was born.
One of the problems with ESG is that stocks are getting left out for non-economic reasons and that potentially leaves alpha on the table. Another big problem is that the ESG data is all different. There are upwards of 20 different rating agencies and among them you could find massive inconsistencies. The exclusions, however, were very consistent.
The biggest issue is defining what is ESG and what isn’t. What are we judging ESG on? Is it business practices, products or something else? Plus, the environmental, governance, and social measurements and qualifications are completely different. Should they be combined or should issuers be looking at individual E, S and G products? ExxonMobil, for example, divested itself of some assets, which scored well on ESG measures, but its energy output has not changed. Tesla’s another example of a company that scores well on the environmental side of the equation, but poorly on governance. Should that be considered an ESG stock or not?
Neuman says that ESG needs to be defined much better, but who defines it? The index providers do a lot of the research today, but ESG has taken a bad turn because it is being used to push the preferences of certain people, not necessarily the investors. Ultimately, ESG investing has a better chance of success if it’s much more targeted and geared towards the client. Some indices and funds have gone so broad-based that they are missing out on a lot of the ESG advantage. ESG overall is a little misleading, but it should come down to what the client wants. Investors need to understand what they own and why.
Other key takeaways:
- Companies have gotten better at gamifying the ESG system. They are getting better at understanding how to answer the due diligence questions in order to look better. It is another reason why advisors and investors need to do their own research and become more targeted.
- Many advisors feel that even if there is not great outperformance potential, it’s a great opportunity to engage with clients.
- The view on ESG has forever changed because of what’s happened with Russia. Now we are focusing on what we have done to address ESG concerns.
- There is likely more political influence over who and how ESG gets defined.
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