I had a great conversation with Roger Mortimer, a long-term hydrogen investor, and an ardent ESG fan.
1/ What I learned was counterintuitive and very relevant for those who invest in 'ESG'.
2/ Key takeaway? STOP investing in ESG portfolios if you want to be a good ESG investor!
1/ What I learned was counterintuitive and very relevant for those who invest in 'ESG'.
2/ Key takeaway? STOP investing in ESG portfolios if you want to be a good ESG investor!
3/
Not intuitive, right? I'll explain.
Let's establish the ultimate ESG investor goal: earn higher returns and create positive ESG change.
"Do well by doing good" is what the investment hippies call it.
Not intuitive, right? I'll explain.
Let's establish the ultimate ESG investor goal: earn higher returns and create positive ESG change.
"Do well by doing good" is what the investment hippies call it.
4/
As a graduate of the free-market-loving, efficient-market-hugging, Chicago finance PhD program, my gut instinct to those pitching "do well by doing good" is "bullsh#$."
As a graduate of the free-market-loving, efficient-market-hugging, Chicago finance PhD program, my gut instinct to those pitching "do well by doing good" is "bullsh#$."
5/
Of course, the most famous Chicago PhD ever -- Cliff Asness @CliffordAsness -- has a great article explaining exactly why it is impossible to do well by doing good.
aqr.com/Insights/Persp…
Of course, the most famous Chicago PhD ever -- Cliff Asness @CliffordAsness -- has a great article explaining exactly why it is impossible to do well by doing good.
aqr.com/Insights/Persp…
6/
Tl;DR: if cost of capital goes up for polluters via ESG investor allocation decisions, expected returns must go up, all else equal.
And if the cost of capital goes down for uber-ESG firms via investor allocation decisions, expected returns must go down, all else equal.
Tl;DR: if cost of capital goes up for polluters via ESG investor allocation decisions, expected returns must go up, all else equal.
And if the cost of capital goes down for uber-ESG firms via investor allocation decisions, expected returns must go down, all else equal.
7/
In short, earning higher expected returns and creating positive ESG change is impossible in equilibrium.
One can't argue with Asness' logic via the lens of financial economics. Master Yoda Fama did a good job training his Jedi Knight Cliff Skywalker.
In short, earning higher expected returns and creating positive ESG change is impossible in equilibrium.
One can't argue with Asness' logic via the lens of financial economics. Master Yoda Fama did a good job training his Jedi Knight Cliff Skywalker.
8/
But Cliff is discussing an equilibrium outcome, which masks a 'transition to efficiency' opportunity which could actually lead to a situation where one 'does well by doing good.'
So how does one plausibly earn higher returns and create positive ESG change?
But Cliff is discussing an equilibrium outcome, which masks a 'transition to efficiency' opportunity which could actually lead to a situation where one 'does well by doing good.'
So how does one plausibly earn higher returns and create positive ESG change?
9/
First, the incorrect answer: stop pursuing the typical ESG investor path.
What do most ESG investors do? They look for portfolios (or individual stocks) that currently pursue strong ESG policies that are quantifiable and readily observable.
First, the incorrect answer: stop pursuing the typical ESG investor path.
What do most ESG investors do? They look for portfolios (or individual stocks) that currently pursue strong ESG policies that are quantifiable and readily observable.
10/
Second, let us assume that there are hordes of naive ESG investors who will continue to follow the standard ESG investor path.
Okay, so why is 'naive ESG' investor the worst way to pursue ESG investing?
Second, let us assume that there are hordes of naive ESG investors who will continue to follow the standard ESG investor path.
Okay, so why is 'naive ESG' investor the worst way to pursue ESG investing?
11/
The problem with naive ESG investing is the following: Arguably, if strong ESG characteristics are readily observable and actively being implemented by a firm, it is likely that any potential benefits from strong ESG policies are already priced into the stock.
The problem with naive ESG investing is the following: Arguably, if strong ESG characteristics are readily observable and actively being implemented by a firm, it is likely that any potential benefits from strong ESG policies are already priced into the stock.
12/
And because so many ESG investors are attracted to these securities with easily observable ESG characteristis, these firms already enjoy lower cost of capital, and thus, by design, these investors can expect to earn lower returns, all else equal.
And because so many ESG investors are attracted to these securities with easily observable ESG characteristis, these firms already enjoy lower cost of capital, and thus, by design, these investors can expect to earn lower returns, all else equal.
13/
Yuck. Low expected returns and no ability to affect additional ESG change (ESG policies are already in place!). A lose-lose situation!!!
Yuck. Low expected returns and no ability to affect additional ESG change (ESG policies are already in place!). A lose-lose situation!!!
14/
What's a better approach? How can we earn higher returns and affect positive ESG change?
Idea: front-run positive changes in ESG perception/policies by buying stocks with poor ESG characteristics and flip them to naive ESG investors.
What's a better approach? How can we earn higher returns and affect positive ESG change?
Idea: front-run positive changes in ESG perception/policies by buying stocks with poor ESG characteristics and flip them to naive ESG investors.
15/
How does this strategy work?
1) Identity firms with terrible currently observable ESG metrics.
How does this strategy work?
1) Identity firms with terrible currently observable ESG metrics.
2) Among these firms, do the fundamental work to identify firms who are likely to adopt ESG policies over time due to economic incentives and/or can be influenced to adopt ESG policies over time.
17/
3) Buy the basket of poor ESG ranked firms with the promise of being strong ESG firms in the future.
3) Buy the basket of poor ESG ranked firms with the promise of being strong ESG firms in the future.
18/
4) Actively fight for better ESG policies and/or wait for economic incentives to drive strong ESG policies.
4) Actively fight for better ESG policies and/or wait for economic incentives to drive strong ESG policies.
19/
4) As time passes, your portfolio of "loser ESG firms" will become "strong ESG firms". Sell your portfolio to naive ESG investors at higher prices.
4) As time passes, your portfolio of "loser ESG firms" will become "strong ESG firms". Sell your portfolio to naive ESG investors at higher prices.
20/
5) Rinse. Repeat. And Do Well By Doing Good.
QED.
5) Rinse. Repeat. And Do Well By Doing Good.
QED.
cc @RogerMortimerH2 who isn't active on Twitter but I think he should be!
• • •
Missing some Tweet in this thread? You can try to
force a refresh
