What’s the truth behind ‘ESG’ Investing?

Happy 4th of July, The Investor’s Podcast Network Community!

Welcome to The Investor’s Podcast’s new daily newsletter: We Study Markets.

We’re best known for our industry-leading podcasts, like We Study Billionaires, but we also wanted to bring you more frequent, written content too — thus, We Study Markets, the newsletter, was born!

In this new newsletter, we’ll deliver you useful insights each day, Monday through Friday, to better track and understand financial markets, and what it means for you, in just a few minutes.

Whether you’re a seasoned investor or just starting out, we’re here to help.

Markets are closed today, but we couldn’t resist sharing some of the topics on our mind, so before the fireworks tonight, let’s talk markets.

Here we go!

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In The News

⚠️ Emerging markets are getting crushed by the strong dollar (CNBC)

Explained:

• The U.S dollar is the traditional safe-haven asset for global investors. When times look uncertain, the dollar’s strong network effects and broad usage, complemented by the United State’s deeply liquid financial markets and robust legal system, help the dollar stand out. The knock-on effects of this can be extensive, though, as many emerging market countries have debt denominated in dollars in addition to much of their trade and commodity imports. When the dollar strengthens generally, these countries’ currencies may depreciate against it, so it’s more challenging for them to pay back debts while making many necessary imports more expensive.

What to do:

• With surging energy and commodity prices, a strong dollar only makes things worse, and emerging market countries will likely be the first hit by global supply shortages. This poses a particularly challenging environment for equities in these markets. Investors may be wise to consider limiting large allocations to individual stocks and funds based in such vulnerable countries, while the more sophisticated among us may even choose to bet against these countries’ credit worthiness using credit default swaps.

😒 Skyrocketing inflation hasn’t done much for the price of gold (WSJ)

Explained:

• Gold is a controversial investment (potentially even controversial as an ‘investment’ but I digress…) though its recurring history as a currency and financial asset across cultures and time has fueled its continued value still today despite limited use cases. Behind this narrative is often the belief that gold is a store of value during periods of inflation and global turmoil. However, gold’s price has notably been flat this year despite troubling macroeconomic conditions. As interest rates rise rapidly in response to inflation, the opportunity costs of owning gold increase dramatically, because investors can park excess cash in relatively safe Treasury bonds that pay meaningful interest, whereas owning physical gold produces no direct cash flows.
• There are certainly different ways to own gold as well including possessing and storing it yourself which tends to come with added costs (i.e. buying a safe, insurance), while other options include gold-backed ETFs such as ticker: GLD that have embedded management fees. If one were to try and generate cash flows from gold, this would most likely be done by investing in gold miners who are correlated with the price of gold, but these returns bear additional risks related to the unit economics of mining, company management, leverage, government regulations etc.

What to do:

• Should we hit a severe recession over the coming months and year, interest rates may drop to stimulate the economy. For investors who expect that the Federal Reserve’s rapid tightening will push the world economy into recession, a bet on gold could prove lucrative, as the precious metal may benefit from declining real interest rates. For purists, physical bullion is an option, though others will find gold-backed ETFs sufficient, whereas gold miners are a less direct approach which invokes an element of equity-risk into your precious metals strategy.

🥶 IPO Markets freeze over, lowering fees significantly for investment banks (Reuters)

Explained:

• After booming primary markets in 2021, meaning record numbers of companies taking advantage of all-time highs in the stock market and low interest rates to raise money either through stock issuance or incurring debt, the era was defined notably by the infamous ‘SPAC boom.’ Since investment banks are the intermediaries who facilitate these sorts of activities on behalf of companies, they collect sizable fees every time deals are undertaken from mergers and acquisitions to initial public offerings (IPOs) to bond issuance. With markets getting crushed in 2022 though, the party is seemingly over, as the appetite for new shares and debt has quickly dried up. Fees from deals in equity capital markets declined 74% this quarter, marking a 13-year low.

What to do:

• If you had hopes of finally investing in your favorite private company, well, you’ll likely have to hold off on that for a while, as the prospect for a broad resurgence in new IPO listings remains bleak. This has been particularly painful for those who invested in popular SPACs in 2021. The past year has been a good reminder that investors ought to be extremely cautious when dealing with new and relatively unproven companies, especially those that are unprofitable.

Deep Dive: ESG Investing

Overview

Over the past few years, talks of environmental, social, and governance (ESG) concerns have come to increasingly dominate the investing world, as society demands more corporate responsibility. It’s worth considering then whether such ‘ESG’ strategies with promised outperformance have any teeth.

What’s the issue?

A myriad of Wall Street products have launched that claim to be “ESG-friendly”, while charging higher fees for these seemingly socially responsible services.

While many may now see an option to select special funds in their retirement accounts that align with ‘sustainable investing’ and claim to be promoting a cleaner, safer, and more equitable world, the mechanism for facilitating social change by allocating a fraction of your 401K to a Blackrock ESG ETF is dubious.

Since these sorts of investments are made only on the secondary market, additional portfolio allocations to companies with high ESG scores can only drive marginal change at best, as in theory, these companies would benefit from issuing equity at higher prices and reduce their cost of capital.

However, companies are much more inclined to issue debt, and even buy back stock, in a world with trillions of dollars yielding low interest rates, as the cost from equity dilution in issuing new shares is typically quite high. The path towards facilitating social change via Wall Street appears unclear.

So what?

If we can’t adequately support ESG-compliant companies, and punish those that aren’t through equity markets, maybe we need to focus on changing institutional investor mandates to restrict the companies to which they can provide direct financing?

This sounds more promising, but with many actors both domestically and globally, actually cutting off carbon-heavy industries, tobacco/alcohol companies, or weapons producers from capital feels like a big game of cat and mouse. Recently, the definition of ESG compliance has been quite controversial, amidst the Russian invasion of Ukraine, as oil and gas companies and defense contractors are now seen as strategic assets.

With rapidly rising gas prices and a glaring European dependence on Russian natural gas, in addition to the continued need for external flows of weapons and ammunition to Ukraine, enthusiasm for restricting further investment in these areas appears to come with a trade-off in weakening the West’s ability to punish Russia for its malfeasance.

As to whether investing in ESG ETFs generates strong returns, well, this also fails the smell test. For ESG funds to generate persistent outperformance, there must be some informational asymmetry that global investors chronically underrate. Given that environmental costs are no new phenomenon, it seems hard to imagine that many of the world’s most sophisticated investors generally have failed to account for ESG considerations in the discount rates they apply to securities.

On the Richer, Wiser, Happier podcast episode 05, famed professor of finance Aswath Damodaran discusses this dynamic further.

Here’s the point:

In considering all this, we must ask, what it even means to be ESG-compliant, and how can ESG scores be calculated objectively?

Of course, we should follow the incentives here, as Charlie Munger would advise us to do. Without a clear set of accepted rules defined by governments and multi-national organizations on measuring and scoring ESG performance, we are in some sense defaulting to Wall Street as our moral compass, which may backfire.

Since these products tend to be more expensive than typical passive index funds, investors may benefit from viewing these offerings skeptically while sticking to broad strategies with the lowest costs.

Conclusion

This is not to criticize those hoping for a better world with fewer CO2 emissions, more socially conscious companies, diverse corporate boards, cleaner water, and greater use of renewable energy, but rather a reflection of where we are in that transition process.

We must continue identifying companies that we believe can operate sustainably and ethically in the long run, but perhaps relying on active ESG ETFs and other similar products will ultimately drag our portfolios in higher fees and fail to achieve their stated mission.

Quote of the Day

“Only when the tide goes out do you find who’s been swimming naked.”

-Warren Buffett

Meaning

Interest rates are rising fast, the S&P 500 is in a bear market, crypto market firms are blowing up, and consumer sentiment is near record lows in light of spiking food, energy, and housing prices, so it feels like one of those times we will soon learn who has been swimming naked.

Needless to say, this does not refer to over-exuberant teens enjoying their summer break, but rather is meant to reference companies and other financial market participants who have been managing their risk
poorly.

This could mean they’ve taken on too much debt, made risky bets and investments, or even worse, used debt to make those risky bets. Using borrowed money for any investment magnifies both the upside and the downside. When the economic cycle turns, as it appears to be possibly doing now, you start to see a whole lot more of that downside.

Some companies will simply suffer from an accumulation of seemingly small but poor choices over time. Regardless, as financial conditions tighten and the future becomes more uncertain, bankruptcies for those swimming naked become increasingly likely.

Passive vs Active Investing

What to know

The terms ‘active’ and ‘passive’ are thrown around a lot in financial jargon, but what do they actually mean?

Essentially, these are the two main philosophies for investing.

• Passive investing methods are typically simpler, as investors choose to allocate money to index funds that are broadly based and defined by fundamental rules. For example, a passive investor may choose to invest in a mutual fund or ETF (exchange-traded fund) that holds all publicly traded companies in the U.S. This would be a type of index fund, and the advantage is that you now own a small slice of every American stock without making any specific bets. Not so bad, or hard, huh?
• Active investing requires investors to make well-researched or algorithmic stock bets. The S&P 500’s performance is often their benchmark to beat. This index is arguably the most famous, since it represents the returns of approximately the largest 500 U.S. public companies. From hedge fund managers to amateur stock enthusiasts, these active investors frequently design unique tactics to beat the stock market averages.
  Are you an active investor or a passive investor?

Personally, I’m a mix of both.

See You Next Time!

That’s it for today. Thanks for reading this edition of We Study Markets, and if you liked our newsletter, keep an eye out for them on weekdays around 12 pm EST.

Enjoy the holiday!