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The Hottest Trend in Investing Is Mostly a Fad

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IAnn March, 19 Republican governors issued a statement Warned of a “direct threat to the American economy, individual economic freedom, and our way of life”. The threat in question was not one of the classic objects of conservative concern, such as high taxes, government regulation or social medicine. Instead, it was a bugbear of a more recent vintage: ESG investing.

ESG, which stands for “environmental, social and governance,” allows investors to put their money into companies that care about not only their bottom line, but their impact on the world. ESG has been one of the hottest investing trends over the last five years. There are now multiple ESG indexes and hundreds of ESG funds, including the largest institutional investors, which have collectively amassed trillions of dollars in assets.

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Given that no one is forcing anyone to invest in these funds, you can view this as the free market at work. But for Republicans, the boom has been nothing short of a disaster, turning corporate executives into soft-hearted people who put diversity and environmentalism ahead of the bottom line. wall street journal opinion page publishes Nonstop Serious coverage Its. Florida, Ground Zero for Attempt to Use State Power to Punish Corporations for “Waking Up” pass A law passed earlier this month prohibits state and local officials from considering ESG goals when making investments.

Conservative rhetoric about ESG investing may be politically expedient, but it is completely far from reality. ESG ratings generally aren’t, it turns out, what most people think they measure. The most reprehensible thing about ESG isn’t that it propels corporations to pursue progressive environmental and social goals. Such that it pretends, while in fact does very little.

Teathe roots of ESG investing goes back to the rise in the 1960s of what was then called “socially responsible investing”. This approach is primarily known as “negative screening”: No Investing in companies involved in products or practices considered harmful or unethical, such as support for tobacco, nuclear weapons and apartheid.

In the 1990s, some small investment firms started Leading The idea that one can obtain greater returns by identifying and investing in companies with excellent social or environmental performance. The theory was that these types of corporations use resources more efficiently, have a lower risk profile, and are better positioned to deal with future regulations. Initially, this type of positive screening was catered to a niche market. It was a labor-intensive undertaking that required extensive research and direct interaction with corporate executives. But by the mid-2000s, there was widespread interest in investing in companies that were doing well, especially with respect to climate change, and more hostility to the idea that companies should prioritize shareholder returns. . A demand emerged for what we now call ESG investing, and as is typical of capitalist markets, supply quickly outgrew that demand.

Over the past few years, what you might call ESG-rating agencies have formed, many of them as new divisions within existing companies, each set out to rate the corporations’ ESG performance in exactly the same way. The way credit-rating agencies assess. Creditworthiness of corporate bonds. Today you can choose from ratings from Moody’s, MSCI, S&P, Refinitiv, and others. Along with the ratings came stock indexes and exchange-traded funds. Socially conscious retail investors now have an extensive menu of ESG funds ready to choose from—no research required. The sales pitch remains the same as it was in the 1990s: ESG investing will not only imbibe your sanity; This will allow you to outperform the market. You can do better by doing good.

It must be said, is a great pitch. The only problem is that it’s mostly smoke and mirrors.

Start with those ratings. An ordinary investor would reasonably assume that if a company has a high ESG rating, it must be doing much to curb carbon emissions and pollution or improve diversity in its workforce or, ideally, both. Means how the marketing of rating is done. MSCI, one of the most influential ESG-rating firms, describes himself as “enabling the investment community to make better decisions for a better world” and declare, “We are driven by the belief that [return on investment] It also means a return to the community, stability and future that we all share.

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In fact, MSCI’s ESG rating doesn’t measure how much a company is doing to combat climate change. Instead, as an intense 2021 Bloomberg Investigation Has shownThe “environmental” portion of the rating measures how climate change is likely to affect a company’s business and how much the company is doing to reduce that risk. Therefore, if MSCI feels that climate change is not a major threat to a particular corporation, it does not consider carbon emissions in determining that firm’s environmental rating – even if that corporation is a large emitter. So a company like McDonald’s can upgrade its ESG score even though its overall carbon emissions have increased.

Furthermore, the ESG framework smashes together a wide range of variables into a single rating, including one category—corporate governance—that has nothing in common with environmental and social values. A company may score well on governance because it limits the power of the CEO, has an independent board of directors, and is transparent and open with shareholders. It’s all economically valuable, but there’s nothing inherently good for the world about it. A sinister but well-governed corporation will accomplish its sinister goals more effectively. Yet governance constitutes an important component in a company’s score and in Bloomberg Study accounted for the highest percentage of upgrades. One consequence of this is that a company that has a mediocre record on high carbon emissions and diversity, but excellent corporate governance, may end up with a very high overall ESG score.

Ssome of these The problems could be addressed by creating ratings that actually focus on reducing emissions, or by creating an ES index instead of ESG. But another issue will remain: Different agencies provide widely different ratings. A 2019 Study For example, economists Florian Berg, Julian Kolbel and Roberto Rigobone found that the ratings of the six largest agencies correlate poorly with each other, and that the biggest source of disagreement is how the different agencies measure the same parameters. Are. One agency may say that a company is a leader in its sector, while another agency may view it as an average performer.

On top of all that, ESG indexes and funds don’t always do much screening to begin with. When you invest in an ESG fund, you might think you’re buying into a highly curated selection of positive-outlier companies. In reality, it will often look very similar to a typical market-wide index fund. 10 Largest Holdings in the S&P 500 ESG Index include Big Tech companies such as Apple, Microsoft and Alphabet; Big banks like JPMorgan Chase; And, incredibly, ExxonMobil. This has two consequences: first, ESG investors don’t always put their money toward companies that are doing extraordinary work on the environmental or diversity fronts; Second, to the extent that an ESG fund does well, it is often simply because the market as a whole is doing well — yet ESG funds typically have higher costs than index funds.

ESG investors, then, don’t always, or even generally, get what they think they’re paying for, which means that conservative claims that companies need to meet ESG criteria are counterproductive. Contradicting myself, it’s too much. The ESG boom has perhaps encouraged companies to improve their disclosures about issues such as emissions and to think more concretely about the climate change risk that is posed to their operations. But it is not a vehicle for awakening capitalism.

Indeed, if the ESG boom has had any systemic effect, it may be in weakening the demand for government action by fostering the illusion that corporations can solve, and indeed are solving, the world’s problems. For example, in 2021, Larry Fink, CEO of investment giant BlackRock and favorite villain of the anti-ESG crowd, argued against Mandating climate-risk disclosure. Thanks to self-regulation, he said, “we don’t really need government change or regulatory change.” It’s a message that Republicans generally will find quite appealing. Instead of trying to bury ESG capitalism, free market conservatives should actually be praising it.