Joachim Clement, CFA, most recent author Geopolitics: The interaction between geopolitics, economics and investment From the CFA Institute Research Foundation.
There are often two criticisms of environmental, social and governance (ESG) investments that I can’t really tolerate. There is a quality of truth about them and academics sometimes say “like” reasoning. For my younger readers, the word truthful was coined by Stephen Colbert during his hosting days. Colbert reports Comedy Central. Wikipedia defines it as follows:
“Truth Belief or conviction that a particular statement is true based on the insights or ideas of some person or persons without considering evidence, reasoning, intellectual test or facts.
A fact-based argument in investment is that the growth of index funds and exchange-traded funds (ETFs) makes the market less efficient and creates a stock market bubble. This can be true if index investors calculate a huge portion of assets (AUM) under management. But today, index funds manage less than 30% of all assets. The index-fund-create-bubble claim ignores or assumes the fact that active investors who account for the remaining 70% cannot form an independent opinion and blindly follow the benchmark index, which is not flattering.
ESG Investments, similarly criticizes the fact that portfolios managed with ESG overlays There is To make their conventional colleagues inferior. Why? This is because such overlays are “optimized with additional limitations”. Thus ESG investment means excluding oil and gas or similar ESG-challenged companies from the portfolio. Thus, modern portfolio theory indicates that efficient frontier inclusion of these stocks cannot lead to the same return.
There are two problems with this debate. First, it assumes that ESG investment is the same as excluding certain companies or sectors from a portfolio. Thus many people are still moving towards ESG investment and this is, to be honest, the worst way to do it. Not only do exclusion screens work, they do the opposite.
Fortunately, serious ESG investors have been expelled from the outside world. The next iteration of the ESG was the best class method. The ESG portfolio is invested in all sectors but only in companies with the lowest ESG risk in each sector.
Each ESG indicator follows this course. To be sure, top-notch investing has its own problems, so I’m not endorsing it. But this single change refutes the notion that ESG investments may not be as risk-averse as conventional investments. It shows the performance of MSCI World Index and MSCI World ESG Index.
MSCI AC World vs. MSCI AC World ESG Leader
The two indicators are virtually identical. Technically, the ESG index has an annual return of 5.35% since the beginning of 2007, compared to 5.32% of the conventional index. The same practice gives the same results with regional and country indices. The performance of the ESG index over the last decade or so has been more or less reflected in the conventional index.
However, this is not surprising. The best-in-class approach mimics as close strategies as possible. Which was set up to fix most ESG indicators.
Most active fund managers do not exceed the conventional market index and since the ESG indicators are practically the same as the conventional index, this means that the majority of active fund managers do not exceed the ESG index either.
Which brings me to the second flawed critique of ESG investments. That ESG investment There is This is to weaken its conventional adversary because it is a theoretical argument optimized with additional restrictions: this may be true in an ideal world but in reality it is not true at all. Modern portfolio theory assumes that we can predict the correlation between future income, volatility and assets with extreme accuracy. But in reality, every prediction has an error of conjecture. The recent presidential election in the United States is proof of this. Those who were surprised by the closeness of the results either did not understand the error of the estimate or did not pay attention.
The same goes for portfolio optimization. I’ve written about approximate uncertainty and how it ruins our investment process in the real world here, here, here, here, here, here, here, here and here. I should have thought the lesson would have sunk by now, but obviously it didn’t.
In the end, the uncertainty surrounding our forecasts is so large that any modern ESG investment can keep us in our portfolio. Acknowledging fully integrated ESG investment as a limited optimization is an argument limited by the truth itself. And that’s the word.
Be sure to learn more from Joachim Clement, CFA 7 Mistakes Every Investor Makes (And How To Avoid Them) And Risk profiling and tolerance, And sign up for it Clement on investment Comment
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All posts are the author’s opinion. As such, they should not be construed as investment advice, or the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
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