The truthiness of ESG criticism

When it comes to the critics of ESG investing there are a couple of often-repeated arguments that I really can’t stand. They have the quality of truthiness to them, or what academics sometimes call more politely “as if” arguments. For my younger readers, the term truthiness was coined by Stephen Colbert during his days on Comedy Central hosting The Colbert Report. The always accurate (just kidding) Wikipedia defines truthiness as:

Truthiness is the belief or assertion that a particular statement is true based on the intuition or perceptions of some individual or individuals, without regard to evidence, logic, intellectual examination, or facts.

One such truthiness argument in investing that you might have seen is the argument that the rise of index funds and ETFs make markets inefficient and cause stock market bubbles. This may be true if index investors account for 100% or at least the vast majority of assets under management, but today, the assets managed by index funds are typically less than 30% of all assets and so a clear minority. Claiming that the rise of index funds creates stock market bubbles simply ignores this fact (or assumes that the remaining 70% of active investors are unable to form an independent opinion and blindly follow benchmark indices, which isn’t flattering either).

In ESG investing, one such argument is that portfolios managed with an ESG overlay have to underperform conventional portfolio because it is an “optimisation with additional constraints.” 

The argument is that ESG investing equals investing with constraints like the exclusion of oil & gas companies from the portfolio. Thus, modern portfolio theory dictates that the efficient frontier cannot lead to the same return as an efficient frontier that includes these stocks. 

The fault of this argument is twofold.

First, it assumes that ESG investing is the same as excluding certain companies or sectors from the portfolio. This is how many people still approach ESG investing and it is, quite frankly, the worst way to do it. I have argued before that exclusions not only do not work but are counterproductive.

Luckily, serious ESG investors have moved on from exclusions a long time ago. The next iteration of ESG used to be the best-in-class approach, which allowed ESG portfolios to invest in all sectors but only in the best companies in each sector with the lowest ESG risk. This approach is at the heart of every ESG index you can find. Best-in-class investing has its very own problems and you should not consider the next few paragraphs as me endorsing best-in-class investing, but it is easy to show that this modification of ESG investing already refutes the argument that ESG investing cannot possibly have the same risk-return trade-off as conventional investing. Take a look at the performance of the MSCI World Index vs. the MSCI World ESG Leaders Index below. 

MSCI AC World vs. MSCI AC World ESG Leaders 

Source: MSCI

There is virtually no difference between the two indices. Technically, the annualised performance of the ESG index since its inception in 2007 is 5.35% and of the conventional MSCI index, it is 5.32%. You can do the same exercise with regional and country indices and you will always come up with the same results. ESG indices have performed virtually identical to conventional indices over the last decade or more.

That, by the way, shouldn’t surprise you, because the best-in-class approach allows investors to mimic conventional approaches as closely as possible and this is exactly what most ESG indices were set up to do: Be as close to the conventional market index as possible. 

We know that the majority of active fund managers do not outperform conventional market indices and since ESG indices have virtually the same performance as conventional indices, this also means that the majority of active fund managers do not outperform ESG indices.

Which brings me to the second fault in the argument against ESG investing. Saying that ESG investing has to underperform conventional investing because it is optimisation with additional restrictions is a theoretical argument that may be true in an ideal world but isn’t true in practice. Modern portfolio theory assumes that we are able to forecast future returns, volatilities, and correlations between assets with extreme precision. But in reality, there are estimation errors around every forecast. The recent Presidential election in the United States has once more shown this to be true. If you are among the people who were surprised about the closeness of the race between Biden and Trump, you either have not understood estimation errors or not paid attention.

The same is true for portfolio optimisation. I have written about estimation uncertainty and how it ruins your investment process in the real world here, here, here, here, here, here, here, here, and here. I should think that lesson has sunk in now, but obviously not.

In the end, the uncertainties around your forecasts are so much bigger than any constraints that modern ESG investing (i.e. fully integrated ESG investing as a method to manage investment risks) may put on your portfolio.

People who continue to make the argument that ESG investing is constrained optimisation make an argument as if they are uneducated about the subject or as if they are unwilling to learn about it.