Today, Explained - Is ethical investing a sham?

Episode Date: July 19, 2023

Republican presidential candidates have a bone to pick with ESG investments. So does James Surowiecki, contributing writer at The Atlantic. This episode was produced by Jon Ehrens, edited by Amina Al-Sadi, fact-checked by Laura Bullard, engineered by Michael Raphael with help from Patrick Boyd, and hosted by Sean Rameswaram. Transcript at vox.com/todayexplained Support Today, Explained by making a financial contribution to Vox! bit.ly/givepodcasts Learn more about your ad choices. Visit podcastchoices.com/adchoices

There are a lot of Republicans running to unseat President Joe Biden. And one of their favorite things to talk about is ESG. They're talking about BlackRock and Vanguard and State Street. And just in case you're wondering what exactly they're talking about, they're talking about financial investment products. They're investing the money of everyday citizens, retirees, 401K plans across this country. And they're using that money of everyday Americans to vote for racial equity audits or environmental constraints that most of those everyday capital owners are not aware of and do not agree with. And more importantly, which do not advance their best financial interests. On Today Explained, we're going to get into ESGs and try and figure

out why, of all the things, retirement funds are a hot-button issue in American politics right now. Get groceries delivered across the GTA from Real Canadian Superstore with PC Express. Shop online for super prices and super savings. Try it today and get up to $75 in PC Optimum Points. Visit superstore.ca to get started. For anyone over 65 years, today. It's played. Sean Ramos-Verm here with James Surowiecki. He's a contributing writer for The Atlantic who recently wrote a piece called

The Hottest Trend in Investing is Mostly a Sham. He was talking about ESG Fund is trying to identify companies that are doing well on a variety of kind of, let's call them socially progressive criteria. Pat, I'd like to buy a vowel. Yeah. E. Well, I thought you might say that. There's that one E and that's it. Environmental, meaning that they are doing a good job of maybe reducing emissions or managing their operations efficiently

from an environmental perspective. S. Social can mean they are working to improve the diversity of their management teams or their workforces. G. Governance generally means that they do a good job of having outside directors on their board of directors, that they do a good job of not allowing the CEO to basically run the company like his or her own personal fiefdom and the like. So the promise of ESG investing is that it's going to allow you to invest your money in companies that are doing

good things as you think of them and that it's also going to allow you to do well so that these companies are also going to give you good returns so that you know you can do well financially while also helping the world in some kind of vague sense. You can find them pretty much from any big mutual fund company. So whether it be BlackRock, which is probably the one that is most associated with ESG funds in the public mind because its CEO, Larry Fink, has historically been a big advocate of ESG investing. BlackRock was built for these times. Or, you know, Vanguard has multiple ESG funds, Fidelity, etc.

How long have these things been around? So the origins of ESG investing really go back to the 1970s. Corporations produce most of the violence in terms of pollution and hazardous products. They corrupt governments. They, in effect, make a mockery out of competition and quality in the marketplaces. They concentrate the economy in the hands of larger and larger corporations. Then it was really called socially responsible investing. And the idea was we want to invest our money in a way that conforms to our values, and we don't want to invest in companies that do things that we think of as immoral, basically.

Among the issues that were important were things like supporting apartheid in South Africa. Or selling tobacco so you wouldn't invest in Philip Morris. Marlboro country is everywhere, anywhere in the land. Or producing weapons. So, you know, this was in the wake of the Vietnam War. So if you didn't want to invest in Lockheed Martin or, I don't know, Dow Chemical, which made napalm. I love the smell of napalm in the morning. Was it controversial?

Were napalm manufacturers up in arms? Was Philip Morris making a stink? My impression is that it was never a big enough movement that companies were really that worked up about it. But it did provoke one of the most famous articles in investment history, which was Milton Friedman's critique of socially responsible investment. The operation of the free market is so essential to foster harmony and peace among the peoples of the world. The economist Milton Friedman, who wrote this sort of famous article

that basically argued that the only thing businesses should be concerned with was the bottom line. Welcome to the 90s, Mr. Bong. In the 1990s, you have this kind of variant of it that emerges, which argued that you could simultaneously do good, but also do well from an investment point of view. There were only a few funds that did it. They tended to be kind of boutique funds. The concept was the market as a whole hasn't really recognized this. And when they do, stocks of these companies are going to rise. And also these companies are going to have higher profits going forward because they've recognized that these certain issues are important, blah, blah, blah.

And again, it was essentially a kind of a niche, a sort of niche market. The acronym ESG really first appears in 2004 in a report that was issued by what's called the United Nations Global Compact. And it basically was a series of suggestions to the finance industry about how they could better apply environmental, social and governance goals to things like asset management and investing and the like. So you start to have a growing demand among individual investors in this concept of, hey, maybe there's a way that we could invest in good companies and not invest in bad companies and also make some money in the process.

And so that's really what you start to see in the 2010s is you start to see a increase in the number of funds that identify themselves explicitly as ESG funds. So the other thing that happens during the same period, and this is really, you can really see it over the last five or six years, this huge boom, is you see the emergence of ESG ratings agencies. So they basically go through, you know, the S&P 500 and they rank them on a variety of ESG criteria. And so once you have those, then you have mutual funds that can say, okay, we're going to use these rankings to, you know, build these funds. And we're going to use computer algorithms to optimize them, blah, blah, blah, blah, blah. And so you end up today with a huge number of funds that identify themselves in one form or another as ESG funds. And you have, at this point,

trillions of dollars under management by these funds. So, you know, that's basically where we are today. And it all works to have a better environmentally conscious, socially conscious, governance conscious financial market in theory? That's the theory. Does it actually play out that way? I think the evidence suggests that in practice, ESG investing does not actually do that great a job of encouraging or contributing to environmental, social, and governance progress, or whatever you want to call it, among corporate America. James is going to tell us why ESGs are really easy to dunk on when we're back on Today Explained. ExxonMobil and Mickey D's are involved. Thank you. back in your pocket. Ramp says they give finance teams unprecedented control and insight into company spend. With Ramp, you're able to issue cards to every employee with limits and restrictions and automate expense reporting so you can stop wasting time at the end of every month.

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Today Explained is back with Jim Surowiecki, who just told us that ESGs, these funds that focus on environmentally-minded or socially-minded or good governance-minded companies, don't actually do a great job of, you know, accomplishing much on these ambitious, lofty fronts. I asked him if there was like an ESG police force or regulatory body holding these funds to account? No. So there is no government body or even industry body that is essentially saying this is what you have to be in order to call yourself an ESG fund. These rankings mainly come from rating agencies, right? So there are now quite a few of them. They're sort of similar to the ratings agencies for credit. These companies do not always or perhaps even often agree with

each other. So depending on what rating agency a fund is paying attention to or using to build its fund, you're going to have different companies in that fund. And in some cases, in extreme versions of it, you have situations where one rating agency may see a company as a very progressive, very sort of highly ranked company. So for instance, recently MSCI had Tesla ranked at the top of the auto industry on ESG issues. And FTSE, which is another agency,

had it ranked as the worst car maker globally. And Sustainalytics, which is another agency, had it kind of in the middle, right? So you have these like really wide ranges. Wow. So you just, again, if you're just an ordinary investor and you're going to an ESG fund, what companies you get in that fund could depend on what agency the fund happened to be based on. And that means what? Anyone can just say, hey, we're ESG. Look at all the great stuff we're doing. In principle, yeah. I mean, when you sign up for a fund, the fund describes what its goals are, what it's supposed to do, what kinds of companies it's investing in. So to that degree, there is some kind of contractual, I don't know if you want

to call it obligation. But yeah, there's no strict definition of what counts as an ESG fund. So that's in part, you're seeing a proliferation of funds that invest in a wide range of companies, some of which that seem self-evidently, okay, yeah, that's a whatever progressive, those are progressive companies, and then others that aren't. The weirdest one is that you will sometimes find ExxonMobil in an ESG fund. Which is weird because the whole thing's like the E stands for environment, right? Yeah. So that's the one that's sort of the most obvious where you're like, how is that possible? It has long been accused of understanding decades ago what its product would do to the planet, but continuing to expand to profit and to question the science of global warming.

You'll sometimes see McDonald's. While McDonald's certainly, as the evidence suggests, it's trying to do a good job of, you know, managing its environmental risk and et cetera, et cetera, you know, it's also selling a huge number of hamburgers every year, so it's a little hard to argue that it's necessarily an environmentally beneficial company. But on the social front, Grimace is purple, and they're very accepting. That's true. That is true. That is true.

Together, Grimace, we could own this town. Yeah. And that also gets to one of the peculiar things about the ESG label, is that it mushes together three different things that are loosely connected to each other at best in the case of environmental and social, and that there's no necessary connection at all between governance and the other two. Governance is actually, I think, the best defined of them. It has the longest history. And there's a very good argument for investing in companies with good governance. And give me an example of good governance. So good governance is a company that has outside directors who are on its board of directors who are genuinely

exercising a supervisory role. These are companies that don't have boards of directors made up of like family members of the CEO where the CEOs don't have an outsized voting interest and can basically do essentially whatever they want to do. The issue, though, is that you can have companies that have excellent governance but that are doing things that are terrible for the environment or in principle that are just not progressive at all on social issues, and vice versa. You can have companies that are doing things that are good for the environment, but that are terrible on governance. One example might be Tesla. I mean, whether Tesla is good for the environment is actually a kind of complicated question, but Tesla historically has had pretty bad governance structures. Because of the way ESG is, it kind of creates this illusion that all these companies are progressive when they're, in fact, not necessarily at all. Yeah, I think it's a high time I ask you that, you know, how do these funds perform?

Yeah. So the original argument for ESG funds was that they could actually outperform. And there just is not much evidence that actually investing in ESG funds is going to lead you to outperform. There's not much evidence that it's going to lead you to underperform either. And, you know, in part, that's because if you actually look at a lot of ESG funds, particularly big ones, the makeup of those funds often resembles the makeup of a typical index fund. Huh. It's not even that different. It's just not that different. So, you know, the biggest holdings in those funds are often companies like Apple, Microsoft, Amazon, Google, or whatever, Alphabet, or JP Morgan. And it's not really that those companies are out there sort of carving out a new path on environmental and social issues.

It's just that their businesses tend not to be very environmentally intensive necessarily. And to the extent that they are, things like server farms and the like, those companies have done a good job of managing their environmental costs just from a bottom line point of view. And so the benefits you're getting into ESG funds primarily for the reason that you think you're going to do better basically by doing good, most ESG funds have higher fees than a typical index fund does. Huh. You got to pay to be ethical? Yeah, you got to pay to be good, basically. And so, you know, that's another reason why you're having this boom in ESG funds. It's not because mutual fund companies are necessarily obsessed with doing good or being

woke. It's actually that it allows, gives them a way to charge a little more. They can make more money off of you. Exactly. By selling you an ESG bundle that includes ExxonMobil. Exactly. I think it speaks to the paradox of ESG investing, which is that even though ESG investing is being portrayed by Republican politicians as this kind of, you know, Trojan horse that's smuggling in, you know, kind of socialist or whatever left wing goals

and turning American corporations into these soft hearted simps. I do think part of this is that there's woke employees in these companies and the inmates have basically run the asylum. So some of the CEOs bend to that. The reality is that because of the way ESG rankings work and the way the industry as a whole has evolved, companies can get very good ESG rankings even if they're not really doing anything at all. That's especially progressive. I think actually the real paradox is that the boom in ESG investing is not really doing most of the things that Republicans say they're upset about. And yet the industry has become an easy target for Republicans to seize on.

Because the point of it is to push corporate investors to the left and then, of course, to punish anyone who dissents. The backlash against ESG investing, you know, over, let's say, the last year or year or two has really kind of led ESG advocates to pull back a bit. So Larry Fink, in his most recent investor letter, did not use the acronym. And that was deliberate. He sort of talked about how it's become such a polarizing term that he kind of just is now backing away from it. It's not business anymore. They're doing it in a personal way. And in the first time in my professional career, a tax went out personal. There is an argument that actually the more hype around the idea that ESG investing is transforming corporate capitalism and making it more environmentally sensitive and more, you know, basically diverse and the like, that the more hype that that idea gets, the less pressure there is on governments to actually do something about climate change. So that there may be a way in which, paradoxically, the more you look to the corporate sector to solve these problems, the less you look to government to solve them. And

that, I think, is problematic because I think it's very unlikely that the corporate sector is going to really come up with solutions to climate change on its own. And so in that sense, you could argue that rather than Republicans being opposed to ESG, they should in fact be like, oh, this is great. This just means there's less chance we're going to have, you know, climate change regulation or things like that. So the great irony is by activating against ESGs, they might be advancing policies they don't like. Exactly. And they were successful. They were successful. Yeah, exactly. Exactly. Now we're going to see more pressure for government regulation on climate change because everyone's like, OK, that ESG thing, we can't really talk

about it anymore. Is there a better way? I mean, this isn't a new idea. For over 50 years, at least, people have been interested in divesting from whatever it might be. Investing in South Africa in the 1970s. Investing in companies that were doing business in Sudan in the early aughts, in getting away from things that are bad for the planet and getting more of their money in companies that are trying to do good. Is there a better way to do that than this ESG idea that seems to be vague and in some cases, utter bullshit? I think there are two ways to do it better. One is honestly just to use the socially responsible investing approach and just don't put your money into companies that are doing

things you don't approve of. So like do the homework yourself. Yeah. And there are, but there are funds that will do that. The mutual fund company state street has an ETF where you can buy the S and P 500 minus fossil fuel companies. The other thing is I do still think the deep green investing model of the 1990s offers interesting promise. So if you have funds where they're spending a lot of time really interrogating executives where they have really rigorous definitions of what they mean by environmental and social standards and the like, I suspect that that kind of investing might, in some cases, be able to identify companies that you really want your money going into and the like. But the thing that investors need to give up on, to some extent, is the idea that they're going to be able to reap higher returns by doing this.

If you are narrowing the range of companies you are investing in and simply refusing to invest in some companies, the chance that you are going to get higher returns by doing that is almost by definition unlikely. But I do think that the idea that I'm going to simultaneously outperform the market and also invest only in, you know, companies I really like, that's the thing I would just kind of I think investors should probably just need to move away from. That's obviously in some degree the premise that the industry has been built on. And I just think there's not much evidence that that's actually true. Are you saying that it's just hard to be an ethical capitalist?

It's hard to be an ethical capitalist and outperform unethical capitalists. That's what I would say. That's a good takeaway. James Surowiecki is a contributing writer at The Atlantic where you can read his piece about ESG. He's also got a book out called The Wisdom of Crowds. It's all about how large groups of people are smarter than an elite few. Sorry, elites. Our program today was produced by John Ahrens. We were edited by Amina Alsadi,

fact-checked by Laura Bullard, and engineered by Patrick Boyd and Michael Rayfield. I'm Sean Ramos-Virum. This is Today Explained. Thank you.