Recent geopolitical events have some Americans blaming environmental, social and governance investing for everything from the high price of oil to the invasion of Ukraine. This is a legitimate concern, as it appears the very essence of what’s good for the world is changing before our very eyes. It is, after all, oil the world now covets, and it’s the high demand for it that is fueling Russia’s invasion (put aside the sky-high prices we’re paying at the pump).

Are ESG investors wrong to demand cleaner energy practices from public companies? Are they wrong to demand tighter gun controls in the United States when we’re sending lethal weapons to Ukraine? Like most things in life, the answers are nuanced.

I’m the author of a book dedicated to ESG investing and a partner of a wealth management firm that recently launched an ESG platform—one that’s seen inflows of nearly $50 million in 18 months. So these questions of course pique my interest. More importantly, I find myself wondering if ESG investing is really helping society or if it’s simply a giant marketing scam that has been “weaponized by phony social justice warriors” (or behemoth financial institutions charging higher fees). That’s what Elon Musk said about the space when his electric car manufacturer, Tesla, was kicked out of the S&P 500 ESG index.

To answer these questions, I looked to Larry Swedroe and Samuel Adams, whose new book, Your Essential Guide to Sustainable Investing (2022), does a fantastic job of collating multiple studies into one comprehensive manual. Swedroe and Adams review academic research to study ESG funds’ claims of higher returns, but also ESG’s overall impact on society. They address the question: Is sustainable investing working to make our world better?

The results are not what you might expect. Here’s what the authors reveal:

• Despite popular claims that ESG returns are comparable to, if not better than, non-ESG returns, Swedroe and Adams argue that sustainable investment strategies should expect lower returns over the long term, even while they initially generate higher returns. The reason is quite simple: Short-term returns are driven by high investor demand, which elevates companies’ stock prices while lowering their cost of capital. In turn, one can expect lower longer term returns from companies with higher P/E ratios.

• Conversely, companies that are not sustainability minded will need to reward investors with a risk premium, since their systemic risk is higher. For example, their risk of corporate scandal due to poor governance (think Wells Fargo), or a major oil spill (BP), will be greater. Their higher returns, like those of the sin stocks of the past, will be required for an investor to purchase their shares, all else being equal. By this logic, we can expect higher returns over the long term for non-sustainable companies. As the adage goes, the greater the risk, the greater the reward, though a higher cost of capital is also to be expected for these less sustainable companies. The authors imply the risk premium is already in play today, it’s just that it’s being overshadowed by the higher demand of investors seeking sustainability.

• Because the higher long-term returns of non-sustainable companies come with increased risk (and vice versa), it’s reasonable to assume long-term risk-adjusted returns may be closer to those of ESG investments.

• If the authors are right, and there are, in fact, lower long-term expected returns from ESG portfolios, investors can compensate by using factors such as size, value, momentum and profitability in their portfolio choices.

• “Brown” companies face a higher cost of capital, so they will be able to invest less. Meanwhile, “green” companies with a lower cost of capital will be able to more easily expand their footprints. In other words, a higher cost of capital puts a company that is not sustainable at a competitive disadvantage.

• As critics of ESG investing have argued for some time, greenwashing is real. Research suggests that behemoth fund managers have exploited investor demand for ESG investing without delivering the goods. One study released in April 2021 (“Do ESG Funds Make Stakeholder-Friendly Investments?” by Aneesh Raghunandan and Shivaram Rajgopal) suggests that these funds are not only more expensive, but that they regularly underperform non-sustainable funds over the same time periods by the same managers. Additionally, the companies making up these “sustainable” funds are actually less sustainable than the companies held by their non-sustainable fund counterparts! This evidence supports the SEC’s April 2021 ESG Risk Alert, which cautioned investors not to over-rely on ESG ratings without further due diligence. The agency cited the ratings’ lack of transparency and conflicting ratings criteria, while noting that some companies have gamed the system by self-reporting their data while some portfolio managers turn a blind eye in exchange for higher fees.

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