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Bogleheads on Investing with Larry Swedroe and Ellen Quigley – Episode 46

Post on: June 1, 2022 by Rick Ferri

Our Bogleheads on Investing podcast, Episode 46 features two guests who discuss Environmental, Social, and Governance (ESG) investing. The first guest is Larry Swedroe, Chief Research Officer of Buckingham Strategic Wealth and the co-author of a new book titled Sustainable Investing with Samuel Adams. The second guest is Dr. Ellen Quigley, Special Advisor to the Chief Financial Officer at the University of Cambridge and a Senior Research Associate in Climate Risk and Sustainable Finance at the Centre for the Study of Existential Risk.

Larry Swedroe

Dr. Ellen Quigley

Rick Ferri: Welcome to Bogleheads on Investing Podcast, podcast number 46.  Today we focus on ESG, environmental social and governance investing. Our two guests are Larry Swedroe. talking about his new book "Sustainable Investing" and Dr. Ellen Quigley, a senior research associate in Climate Risk and Sustainable Finance and also a special advisor to the Chief Financial Officer at the University of Cambridge.

Hi everyone, my name is Rick Ferri, and I'm the host of Bogleheads on Investing.  This episode, as with all episodes, is brought to you by the John C Bogle Center for Financial Literacy, a 501(c)3 nonprofit organization that you could find at Boglecenter.net.  Your tax-deductible contributions are greatly appreciated and don't forget about our Bogleheads Conference coming up this October 12th through the 14th in a suburb of Chicago. There are a few tickets left and we would love to see you there.

Our focus today is on ESG investing.  ESG stands for environmental, social, and governance.  It's the hottest thing in the investment industry right now.  Hundreds of mutual funds and ETFs have been created clamoring for your dollars, enticing you to invest with your conscience in addition to with your money.  But is this really a strategy to take seriously?  Does it actually achieve the goal of environmentally friendly, socially responsible and better governance in how corporations behave and make decisions? Or is ESG a scam, as Elon Musk said recently?

That's my discussion today with two special guests, Larry Swedroe, chief research officer for Buckingham Strategic Wealth and the co-author of a new book called "Sustainable Investing", and Dr. Ellen Quigley who is a senior research associate in Climate Risk and Sustainable Finance at the Center for the Study of Existential Risk and also a special advisor to the Chief Financial Officer at the University of Cambridge. I promise you this will be an interesting podcast.

First up is Larry Swedroe. With no further ado let me introduce Larry Swedroe. Welcome again to the Bogleheads on Investing Podcast Larry.

Larry Swedroe: Good to be back with you, Rick.

Rick Ferri: Larry, your latest book with Samuel Adams is titled "Your Sensible Guide to Sustainable Investing: How to Live Your Lives and Achieve Your Financial Goals with ESG, SRI, and Impact Investing". But before we begin I just want to remind people of who you are. You're the chief research officer for Buckingham Strategic Wealth and have published ten books and have co-authored seven books. And this is the seventh. Now your co-author is Samuel Adams. Could you tell us how you met Sam and why you decided to write this book together?

Larry Swedroe: Yeah, I actually met Sam, probably about 25 years ago. Now where he was, our regional director at Dimensional, so I got to know him there and enjoyed working with him. And then I followed his career. He had moved to England to help start a DFA business there, or grow it. And then he left to follow his passion. He created, I think, the first and maybe still only sustainable real estate fund called Vert [Global Sustainable Real Estate Fund]. The reason I contacted and reached out to Sam to write the book is I noticed there was a dramatic increase, beginning really in 2018, in investor interest in ESG investing, with massive amounts of cash flows. And as usual, academic research tends to follow whatever is the hot subject, and dozens and dozens of papers were being written. And I would write them up so I could convey what the research was finding. And then I said, ”Well it'd be great if we had a book to discuss these issues and show people what the real evidence from empirical research showed, as well as the theory behind it, so you could make a good informed decision about whether you wanted to be an ESG investor or not.”

So I had the knowledge and skills to write the part on the empirical research, the economic theory and the impact of behavior on corporations. And Sam had all of this knowledge as a nationally known speaker in the field about the whole history of the SRI [Socially Responsible Investing] ESG impact investing movement. So I reached out to him and suggested we join forces. And he wrote in effect the first half of the book, with my help, and then he helped me complete the second half. So it was a good fit for Sam, and I enjoyed working with him very much.

Rick Ferri: Yeah, and that did come out, by the way, when I was reading the book. It seemed to me clear that Sam had written the beginning and you wrote the research portion in the middle and then at the end you probably collaborated together on the how to do it portion. Which is how the book is really divided, into three different sections that way. In fact, the first section which defines ESG  investing in the evolution, if you will, of ESG investing. And I just want to point to you the title of your book, the whole title, because in it it kind of talks about one of the issues. The title of your book is Your Sensible Guide to Sustainable Investing: How to Live Your Lives and Achieve Your Financial Goals with ESG, SRI, and Impact Investing. So in the title of your book you have four different strategies, I assume, and it's all very confusing. So if you could, start with how did this whole evolution begin and what all these terms mean? 

Larry Swedroe: Right, it's really a great question. We've struggled with how to title the book because ESG is probably the most familiar term, maybe SRI before that. But I think Sam did a great job in writing the history of the movement. I'll see if I can summarize it briefly. 

So the original thinking was negative or exclusionary screening, to screen out values that you wanted to express. So you might think of the Quakers Civil War screening out any company engaged in the slave trade. Eventually became sort of a holy trinity, if you will, of sin industries tobacco, alcohol, and gambling. You might add pornography, it would be another. Some people add defense industries. And that focused on your personal values, so that's an important distinction here. 

Then we got a movement towards ESG, which focuses on the companies and their behavior in the areas of climate change or environment, social and diversity, and governance. And then the last part became impact investing, which is really a desire to make change in the world and not focusing on the return, mostly. So Rick Ferri decides he wants to help the people in Africa and he's going to invest in a company that helps build water wells so they can get clean water. And he thinks that's a much better way to do it than giving money to some government because he knows the history is often that ends up lining the pockets of politicians and it's not sustainable.

So if you do it through businesses that continue to be ongoing it tends to be more sustainable from that aspect. So the purpose of it is “hey I really want to help the world. If I get a good return that's great, but if not, that's also okay.”

So that's sort of the three ways to break it down. One screen out, that's negative screening, that's the SRI. ESG focuses on the corporate behavior but you still want to achieve your financial goals. And impact investing is sort of almost to the edge of pure philanthropy where you-- it's just the financial end is a secondary consideration--and sustainable investing encompasses all of it.

Rick Ferri: Basically you're putting under the umbrella of sustainable investing, you're putting ESG, well SRI which has to do with screening, ESG which has to do with changing company behavior, and impact investing which has more to do with philanthropy and you're putting it all under sustainable investing.

Larry Swedroe: Impact investing that's just closer to financial, there's still a financial incentive because you're hoping to get a return but that's not the main objective

Rick Ferri: Okay. And then there are other things too, and I just want to go through this laundry list of names. Green investing, responsible investing, value-based investing, ethical investing, purposeful investing. I mean is this all just one sub level of one of these other ones?

Larry Swedroe: Yeah green just refers to companies that have, say, good scores from an ESG  perspective. Then you have on the flip side of green or brown or sin stocks, values driven is really SRI, a type of investing where you're often screening out companies. So it's all under the same umbrella and that's why we chose to use that term sustainable investing as a broad category covering all of them.

Rick Ferri: Okay, that's the first part of the book. That covers the first six chapters, which covers breaking out and defining what all of these different aspects of sustainable investing are. The second part of the book, basically the part that you wrote with Sam's help, had to do with returns and the impact that doing this actually has on society or on companies. And with that I want to go to the introduction because the introduction was written by Burton Malkiel, of course a famous Princeton professor who wrote A Random Walk Down Wall Street

And when I was reading the introduction I was-- and then I read the book. I had to scratch my head. Let me just give you the five things that Malkiel said right in the introduction. And so number one, he said, you know talking about ESG objectives, the term means different things to different people and it is difficult for investors to understand exactly what the ESG portfolios actually achieve. That's number one. Number two, ESG ratings, what you alluded to in the ratings of companies, differ remarkably from one provider to another. He gave an example of carbon footprints where one company would be rated high and another ESG rating service would rate it low. So there's a lot of discrepancy between these ESG ratings. But number three, he mentioned return, and he said investors who wish to invest sustainably should have reasonable expectations including a willingness to accept lower long-run returns. So that was number three. And number four, this is talking about the ESG portion of affecting companies behavior. There is no clear evidence, however, that disinvestment from unsustainable firms has interfered with their ability to raise capital. So those current firms that are excluded, there's no evidence that it had any effect on them financially. And finally, talking about the funds and the way that you would invest in ESG, he said funds are less diversified and more expensive than pure index funds and may well underperform in the long run. So I'm reading this introduction, I'm saying, I mean I give you a lot of credit for publishing it. But what are your comments on all that?

Larry Swedroe: Well that's why we wrote the book, to address every one of those issues. Malkiel is right in raising these questions, Rick, so why don't we take each one of them one at a time. Pick the first one and then we'll go through each of those five, and we'll try to answer them quickly.

Rick Ferri: Okay the first one is why would anybody even want to do this? I mean what is the purpose?

Larry Swedroe: The first answer to that is a lot of people want to express their values through their investing. They don't want to support industries that their belief system doesn't agree with. So whether it's gambling or abortion or you know companies I don't want to support, who don't treat women or minorities fairly. They will want to say, I'm not going to invest in those companies. Companies that pollute the planet aren't investing in sustainable investing and renewables. So that's the main purpose many people at least think about why we want to do sustainable investing, ESG or SRI.

Rick Ferri: Thank you for that. Let me go into the second one talking about ESG ratings. Now first of all, describe companies that do ESG ratings and what they are trying to achieve. And why are they vastly different when you look at the ratings of one provider looking at one company and another provider looking at the same company?

Larry Swedroe: Yeah. So here we have a little bit of bad news for investors. It's not like in the corporate bond market, as you know Rick, they have Fitch, Moody's and S&P, and if you look at Fitch's rating for a company, if it's triple B, the odds are almost a hundred percent the other two ratings will also be triple B. We have a huge disparity in the ratings among seven companies. The major ones include MSCI, Morningstar, Sustain Analytics and a couple of others. So seven big players in the industry and it's very easy to point out why there can be differences. Just think about, for example, you have the three categories of ESG that everyone looks at now. But Rick Ferri, as a rater, decides to give a one-third rating, or equal importance, to each of those. But another rater gives 70 percent to the climate, 20% to the S, and 10% to the G. So you're going to get very different answers. And Rick Ferri decides, when he looks at the social question, he's going to look at how many women and minorities are on the board and another firm will look at the number of managers who are women and minorities, and a third will decide to look at pay gaps. And if they look at all three they may weight them differently. 

On climate you get some really interesting questions because there's not a mandatory requirement that the SEC has about what you have to report. So there's something, a breakdown that is called scope one, scope two, and scope three emissions. Most companies only report what is called scope two. Those are the emissions you create by making your product. Scope one is all the inputs that you get when you get the materials and stuff to then make. And scope three includes the product when it gets delivered to Rick Ferri the consumer.

So you might think, and I'm just making this up, but someone could look at Amazon and say it's a great company. All its electricity is created by solar electricity, other renewables. They don't produce anything, so there's not any pollution there. But then, if you look at scope three, and again I'm making this up, they have all these thousands, if not tens of thousands, of trucks driving around polluting the air. So if you look at scope three, which most companies don't even report on, you could come up with a very different answer. 

And we show in the book very wide dispersions.

Rick Ferri: The company that comes to mind on this issue is Tesla, right. So a Tesla car, you've got to import all of this stuff and it's a lot of plastic, which is petroleum. And so what is the carbon signature of producing the pieces that go to the Tesla manufacturing plant, which then gets assembled – and that's a cost too, but they have a lot of solar panels on the roof, so maybe it's not that much of a carbon footprint – and then the cars go out there and are sold, and there is a carbon footprint to producing the electricity. So in your framework of one, two, three could you look at Tesla.

Larry Swedroe: Yeah, it's a really difficult question, and you can see why you have such a disparity in the ratings. You didn't even cover one important point, which is all the lithium and rare metals that go into the batteries and stuff that all goes in. You're destroying the earth, ripping it apart and using massive amounts of water which the world is short of water in many places. So it's going to depend on how you look at it. And as you point out, you don't use any gasoline but you're you're creating, you're using energy to charge your car and where are the power lines and electricity, and maybe it's a coal plant that's using it.

So it's a very difficult question and our recommendation in the book is really for people to decide on – okay I'm going to go with one rating company, I'll look at how they do things, and just say it may not be perfect, it may not align, but it's better than the alternative of not looking at all. 

Rick Ferri: Now we'll go on to number three. It is Burton Malkiel's view that your expectation of return should be lower. Why would people want to invest in something in the core of their portfolio where the expectation of the equity side is going to be lower than the market?

Larry Swedroe: Yeah it's a very interesting question and it's actually pretty complex and we go to a great deal of time in the book to help people understand the issue. So let's begin with where I always like to begin, which is economic theory. If enough people screen out certain industries or companies, their P/E [price to earnings ratio] will be lower than it would be otherwise. The cost of their debt will be higher. They'll pay a higher interest rate. And the screened in companies will get more cash flow, driving their valuations up and the course of the debt down. And that's nice economic theory. 

There's also a-- so you could call that a taste or a preference-based resulting premium for being a brown or sin investor. There's also a risk-based story because if you're a bad polluter well you could get big problems, like Exxon Valdez and have spent billions of dollars in cleanup costs. If you're a bad employer you could get headline news and have massive lawsuits and no one wants to work for you because you discriminate. If you have bad governance, you don't have good risk controls. And those kinds of companies have lots of problems, often manipulating earnings. You get all these accruals.

So it turns out that the companies that have good ratings tend to be less risky, which is very logical. Less risk of consumer boycotts, frauds, environmental incidents. So there's a risk-based story if you're a green company, if you're investing in safer companies, you should expect lower returns. What's nice in this case is the academic theory lines up perfectly with the empirical evidence right up till 2018 there are studies showing the sin stocks outperform the non-sin stocks by about two and a half to three percent a year depending upon what factor model you benchmarked it against. Or against the S&P 500 about two and a half to three percent as well. 

Along comes this massive trend, which was indexing in the ‘70s, ‘80s, and ‘90s. Very slow trickle and then it exploded in the last 20 years.The SRI movement didn't really pick up steam. It was a little trickle. And in 2018 it started going way up, probably because of the impact on climate change, it was becoming more evident and tens of billions of dollars flew in. So all of the research, as we show in the book, where studies end in 2017, show brown stocks outperforming just as we would expect.

And people could make the decision, I'm willing to pay that price to express my values. That's a personal decision. However, there's now you have what we call conflicting forces. All this cash flows are coming in driving valuations up. And there was a nice paper called Dynamic Equilibrium that talked about this. So what they found is from 2018 through 2020, that three-year period, even though brown stocks should be expected to outperform, by about let's call it three percent, green outperformed by seven. So there was in effect a ten percent greening.

Rick Ferri: But it wasn't a lot of that, just industry sector. I mean most of the green, or a lot of the green, has to do with technology--you know, Google, Microsoft--I  mean obviously we had this big growth spurt in tech, like we did in the late 1990s, and when you look at the ESG footprints of Facebook and so forth, you know they score pretty high, so these portfolios tend to be heavily weighted towards technology stocks. And that may have been true during this technology run but what's going on this year. And I don't know if you track it monthly or such, but isn't it the opposite of what's going on? I mean aren't we back to brown again?

Larry Swedroe: Well first Rick, your point is absolutely right. There's certain industries that tend to be more green. Also it should be obvious that green stocks are going to be more like growth companies because the brown stocks are screened out, they're going to have lower valuations almost by definition and therefore going to be value, and that ‘18 through ‘20 period was the biggest drawdown for value in history. And money was chasing it, as you are well aware most investors are performance chasers. So you had that cash flow pouring in and driving green stocks up. And that led to massive outperformance. And the point we make in the book is that that trend only made the brown or sin premium bigger in the future. But we’re still likely early in the game, Rick. Only a third of US money is invested sustainably, yet the survey shows 80 to 90 percent of the people are interested in investing that way. 

Rick Ferri: Okay I just have one comment about those surveys and then we'll go on to the number four thing. Okay, I read the surveys, I read the questions, and you know it's how you ask the question, because the question is generally asked if there's no difference in your rate of return whether you do ESG or whether you do a total market index fund, would you prefer to to invest in a way that helps the world, yes or no. Obviously if you ask the question that way the answer is going to be, oh no, I mean if there's no difference in my return then I would invest in a way that helps the world.

Larry Swedroe: Yeah you're absolutely right Rick. That's why we don't know whether we're in the third or fourth inning because we're 33 percent and it's going to be 80 percent. Or maybe we're in the eighth inning and it's 33 percent and it's going to go to 40. Nobody knows, but what we do know is the demographics favor more of a trend to sustainable investment because the younger generation is investing more heavily in that way. So I think it's likely we're in maybe the middle innings of this game, where green can continue to at least match or maybe even slightly outperform. But I certainly could be wrong and this year, as you point out, with energy stocks leading the way because of the situation in the Ukraine. That problem, that and other related industries benefiting from that. And value is now outperforming again.

So you know this year probably brown is outperforming. I would not make a bet either way but I think that there is some good hope people could say I want to invest sustainably and because if this trend continues I may get lucky and have green continue to at least match and not have to pay a penalty.

Rick Ferri: Chapter seven gets to his fourth question, which is there's no clear evidence that this investment, meaning not owning the brown stocks, has interfered with their ability to raise capital. So in other words, the impact in the market isn't there, that he can't find it. 

Larry Swedroe: Well, I think he's right and wrong at the same time. So he's right about the point that it doesn't impact the company's ability to raise capital because all stocks have to be owned by somebody and if you screen it out or divest somebody else is going to be a buyer. So there are people who are willing to pay a price, if you will, and get higher expected returns and hold their nose to own these brown companies, if you will, an expectation of getting higher returns for their higher risk.

But what it does do is it does mean you're going to have a higher cost of that capital. And corporate executives, Rick Ferri is CFO of a company in the oil industry, let's say it's Shell Oil and he sees Total Petroleum trading at a higher P/E ratio than him because it gets a higher rating as a sustainable company because it is saying we're not going to abandon our energy investments but we're not going to invest any more in new fields; we're going to take all those profits and invest in renewable sustainable sources. And it turns out the energy industry, the brown dirty industry that lots of people exclude, is generating the most green patents and to me it makes no sense to deprive the good companies of that capital. 

So Malkiel is incorrect, the evidence as we present in the book is very clear that corporate executives are taking note of the fact that if they get poor scores their cost to capital is higher. So they're changing their behavior. They're trying to make efforts at diversity, to get better social scores, attract employees and here's maybe possibly the most important bit of good news. We do know that the evidence for corporate profitability is when you have satisfied employees,  they're more productive and companies are more profitable. People want to work for companies that express and live their values and if you have bad scores it's very tough to attract people, especially the younger generation now. And today we're in the tightest labor market in history. So corporations are well aware they better get good scores and you're seeing more action on diversity, climate issues. And that is changing corporate behavior as well.

There are a whole bunch of studies which we cite showing these impacts, and I think you're reading about it in the press more and more as well. So I think Malkiel was wrong that it's not impacting their behavior. It's not cutting them out from capital but it is impacting their behavior.

Rick Ferri: Okay. So look, the last question that we have time for today. It's all been very interesting, thank you, is that his comments about cost and diversification, where funds are less diversified and more expensive, and may well underperform in the long run, which we already talked about. So talk about the cost of doing this, and how to do it, which is the last part of your book.

Larry Swedroe: Yeah, the costs are, I would say, becoming pretty reasonable. The competition in the space is now like 400 different funds and fund families like Dimensional and Vanguard are having sustainable funds, and they are much more lower cost, you're probably going to pay a little bit more to be a sustainable investor because you're paying for the company to make the effort to get the ratings, do the due diligence, but we're talking more about 10 to 15 type of basis points, not a hundred basis points more. And I think people are willing to make that trade off to be able to express their values. So the costs don't have to be great and you can actually build your own sustainable portfolio with direct indexing. And because of the technology today, Rick, you and I know 20 years ago if you wanted your own SMA, or separately managed account, you probably had 5 or 10 million dollars. Now you could do it with a few hundred thousand and you don't pay more than say 25 or 30 basis points or so to do that.

Rick Ferri: The name of the book is called Your Essential Guide to Sustainable Investing by Larry Swedroe and Sam Adams. Larry, thank you so much for being our guest again on Bogleheads on Investing.

Larry Swedroe: Thank you for having me Rick, pleasure to be with you. 

Rick Ferri: Our next guest is Ellen Quigley. She is an academic and a consultant and has a different view. With no further ado let me introduce Ellen Quigley. Welcome to The Bogleheads on Investing Podcast Ellen. 

Ellen Quigley: Thank you very much Rick. It's a delight to be with you today.

Rick Ferri: Ellen, I wanted to have you on the program because you and I did a podcast together for the University of California at Berkeley a few months ago and you had some great insights into ESG investing, responsible investing and such, because this has been your area of expertise as an academic and a practitioner. So you've really studied this area and you have some really different ideas about it. So could you first tell us a little bit about your background.

Ellen Quigley: Absolutely. So I'm from Saskatoon, Saskatchewan in Canada and I was going to be a historian. That was my goal. Towards the end of my undergraduate degree, when I started to become increasingly panicked about the climate crisis, and it prompted me to take a pause between degrees that stretched to four years and I worked on local environmental issues before realizing that I was being quite ineffective and perhaps not even deploying the kinds of knowledge and tools that would be useful in a kind of replicability way.

So then I went back to university with the express goal of learning enough to contribute in ameaningful way, and then gradually stumbled towards finance and once I got there that's when I started to realize how little any of the accepted tactics actually had any impact.

Rick Ferri: And you ended up getting a master's degree from the University of Oxford, and then you went on to get your PhD and economics education from the University of Cambridge. That's quite a background.

Ellen Quigley:  Well, I've been very lucky.

Rick Ferri: Now you are the senior research associate at Climate Risk and Sustainable Finance at the Center for Study of Existential Risk and also a special advisor to the Chief Financial Officer at the University of Cambridge. So you can tell us a little bit about your current job and this advisor role? 

Ellen Quigley: Yes. And I'll just say my comments in this podcast will be in my role as a senior research associate, as a senior postdoc because I don't want to speak for the University, as the advisor to the CFO. But basically what I end up doing is spending supposedly half of my time researching these issues, and then the other half of my time working with various officials within the university, including the people who manage the endowments of the 31 colleges at Cambridge as well, putting pressure on banks and fund managers to change their practices. And I'll just say that that has been-- I feel very fortunate to have such an unusual mix in academia of the pure research, and a lot of freedom on that side and then the ability to test things out in real world environments. And also because the bursars are a uniquely skeptical crowd. They've really helped me think through these issues in the last few years and that's definitely played a big role in the philosophy I've been cultivating in that time.

Rick Ferri: And your philosophy was written out in a paper that you wrote, which you submitted to the Chief Financial Officer of Cambridge back in December 2021, so recently, called Universal Ownership and Practice: a Practical Investment Framework for Asset Owners. And I found the paper to be very enlightening, very interesting. Let's first talk about the paper itself, because this idea of universal ownership is different than ESG. Could you talk about it, what is universal ownership? 

Ellen Quigley: In a way universal ownership is the opposite of ESG despite in many people's minds having the same goal. They really end up lending themselves to very, very different tactics. So this paper I wrote, the idea behind it is to evaluate the efficacy or lack thereof of ESG, and by that I mean what are the real world outcomes associated with ESG practices. If you look at the philosophy, the kind of approach, ESG is meant to shield an investment, a company, a portfolio, from environmental, social, and governance risks. It's not actually designed to do anything about those risks in the real world.

And what universal ownership does is it flips things around and it says instead of trying to narrowly protect my own portfolio from something like climate change, which by the way surely is impossible, I can't imagine a portfolio that you could construct for 2050 that would be somehow immune to the effects of climate change. Instead of attempting to do the impossible and construct some magic portfolio a long-term investor of capital-- so this could be a retail investor with an index fund, it could be a big pension fund with very long-term time horizon for investing-- they're going to want to preserve where most of their returns come from, which happens to be the health of the overall economy. Most returns come from that, not your ability to outperform the market. I mean this is kind of some of the wisdom behind tracker funds. Actually it just recognizes that fees can cut into the big bulk of your returns, which is this overall market performance. 

And so what universal ownership does is it says what can I do using the tools available to me as an investor to internalize externalities, to reduce systemic risks that are created by the companies that I own. And once you have that philosophy you use pretty much the opposite tools. 

Rick Ferri: Just to clarify. Here in the US an index fund or a broad market index fund is called a tracker fund in the UK because it tracks an index, so a little bit different lingo.

Ellen Quigley: Ah interesting.

Rick Ferri: Okay I want to spend some time on the problems with ESG investing because I think that there's a lot of misconception about what it's supposed to do. I think that here in the US it's been sold by the fund providers as having an impact on society and having an impact on climate change. In other words if you don't invest in these companies, if you disinvest from these companies, they'll get the message and they'll change because they want you to own their stock. Is there any truth to that?

Ellen Quigley: Well I can't find any. Let me just distinguish between two things though that's quite important. So there are some suggestions that if you are a politically important or legitimate institution and you make a big announcement stigmatizing, say fossil fuels, the argument there that I think does hold water – based on the the research behind the divestment report I wrote for the University of Cambridge – I'm now somewhat persuaded that if you have a big announcement from a really legitimate institution it can help to stigmatize an industry that needs to be legislated, and can't be meaningfully legislated until it's viewed as sufficiently bad to invite that legislation. 

So it basically is the precondition to getting the government action that we need, is the argument for say a divestment announcement. But in terms of direct impacts from the sale of shares, most of which by the way are not accompanied by an announcement of any kind, so there's no stigmatizing effect, I just can't find anything other than either a very momentary blip in share prices that quickly reverts to the mean. And actually, accompanying the day of the announcement of a very large share sale as opposed to the day of the sale, which tells you it's much more about perception than anything else.

And then there are some stocks, such as in the tobacco industry, for example, where there's been a mild depression of share prices over time because it's the longest running excluded industry, basically. But even then it doesn't affect the company's behavior. I mean tobacco companies have continued to sell cigarettes this entire time despite being the most targeted by ESG investors for decades.

So I can't find the evidence that people would need to conclude that having filters or exclusions on a public equity portfolio makes any difference at all.

Rick Ferri: So most ESG funds are just buying stocks on the market or they're excluding stock, divesting stock and this is meant at least in some people's mind, the way it's sold here, as though you're making a difference. But in fact, from what you're saying, is if the stock is already out there in the public domain and it's just being traded among different owners, that there is no difference there is no impact.

Ellen Quigley: Yeah, and I think it stems from the way that we use the language in this area. And I was in this camp as well, initially, because I didn't know anything about finance many years ago, and the term investing, if you think oh I’m investing in something, you think you're contributing money to it, right? And I think that's the fundamental misconception here. Because if you're investing in Shell or Exxon, Exxon or Shell they're not getting your money. Your money is going to a different shareholder, a now former shareholder. None of it flows back to the company. They don't care who owns their shares as long as they don't cause trouble in one way or another. But there's no evidence to suggest that that composition of shareholders has had a significant effect. I mean the causal relationship between selling your shares and company behavior change, especially anywhere close to the scale that's needed is just not there.

Rick Ferri: You know, I've always found it a strange idea that by not investing in a company you're going to make a change in the company. Whereas I always learned when I was in business school that it's the owners of the company, the shareholders, the voters, the people who vote, are the ones that make the difference, not the people who have no affiliation with the company in any way and are not shareholders. So this idea of not owning stocks, where you're not going to be voting any shares. How can you make a difference? It doesn't do anything for ESG, it doesn't do anything to change the world but it might make you feel better 

Ellen Quigley: Yeah, which is actually a bit concerning for a couple of reasons. One being that the fact that you've invested in an ESG fund almost always means that you've paid higher fees. And I actually do subscribe to what Tariq Fancy, the former head of sustainable investing at Blackrock has said, which is that ESG is a dangerous placebo because I think that if people think they've done their job, they've invested in an ethical manner, they're likely to just kind of walk away from that whole arena of of impact. You know, as a job done. And actually if they're doing something that has no effect but they've left it alone thinking that it's sorted, that's more dangerous actually than not persisting in that belief.

Rick Ferri: Well let me ask you this because it's something that I have believed for a long time. I've been in the investment business for 35 years and before there was ESG there was socially responsible investing. Always looked at this and looked at the thieves associated with it and never really believed that this was having any impact. There is a lot of belief among many advisors that if you didn't do ESG investing in a typical ESG fund, if you just put your money in a broad market index fund that had extremely low cost fees, that you take the fee savings that you get from doing that and then you donate that to whatever cause you believe in, you'll have a much bigger impact than you would doing ESG investing.

Ellen Quigley: I think that's almost certainly true but I would take it a step further and this is coming from the work of Oliver Hart. He's provided some really interesting insight in this space. He talks about the comparative advantage that a company has in internalizing externalities and that's quite interesting. He talks about this case in which Dupont Chemical had the choice of disposing responsibly of some chemicals at the cost of 19 million or dumping them in the Ohio River, as actually did occur in the ‘80s, and when litigated they discovered that the cost to the rest of the economy was actually 350 million from that spillage. So having prevented it in the first place would have been much better.

If you think about what charitable donations could do to counteract the effects of things that would have been prevented in the first place, I think you might want to do two things. I think you may still want to donate to charities and so on and so forth, but I would also make sure to only work with a fund manager who's willing to help actually get those companies to internalize externalities, and that's rare. Most fund managers are not doing the things that we would need them to do to help move companies in that direction and prevent much greater costs from being absorbed both by society, but also other companies in your portfolio, right? That's the reality of externalities is that they end up depressing the whole market and that's something that we could prevent as owners of companies. 

Rick Ferri: Your paper is on universal ownership. So could you describe for us how do you invest with a universal ownership mindset? 

Ellen Quigley: It's a really important question. I think it's probably one that will still be debated for some time. But what is clear is if you're a universal owner, as in you own a little bit of everything, and this can be because you're an individual with an index fund or because you're a big pension fund and you do just kind of automatically end up owning a bit of everything, then you have to worry about the whole portfolio. When you look at the entire portfolio you can't just think about profit maximizing each individual company or holding, because that can actually end up hurting the overall performance of your portfolio. 

And I might just use Exxon as an example here. If you're a universal owner you may not want Exxon to profit maximize to its fullest extent because that would impose costs on everything else in your portfolio, especially over the long term, because of carbon emissions and climate change. And Exxon is actually responsible for something like two or three percent of all historical emissions. You can actually attach some real figures to the damage already caused by Exxon across one's portfolio, in agriculture and real estate and insurance and food systems. You name it pretty much every sector is already affected, and that's slated to increase. So if you're a universal owner you have to think actually I would prefer that Exxon adopt a transition approach, and every other company to do so as well because even if it costs Exxon a bit more to do that, the overall effect for my portfolio is improved. 

So that's the idea, and then practically speaking how you implement that is you have to think well what is going to actually change a company's behavior and we've already talked about how selling that company's shares in the secondary market probably isn't going to have an effect. So what do you do instead? Well a company like Exxon when building say new fossil fuel infrastructure, a fossil fuel company will probably raise debt. In fact that's how a very large majority of new capital for fossil fuels is raised, through debt. About 90% is the approximate estimate and that comes from loans and from debt issues, bonds. And that means that actually a big focus if you're a universal owner should be on what banks are financing because it's not a very large proportion of their loan book that will be dedicated to something like fossil fuels but the impact will be huge and systemic. So that's a good target for the types of engagements that you may want to have as an investor.

Rick Ferri: I just want to understand what exactly you're saying. You're saying that the way to have an impact on companies' behavior is when they need money and when they're trying to raise money and that's when you bring up these issues as a potential investor.

Ellen Quigley: Yes, and why this is important is that there are some studies to suggest that let's say you're a company wanting to raise debt with a bond issue. You can raise more money and at a better price if you have lots of demand, and the inverse is also true. If you don't have sufficient demand you're going to be able to raise less money and at a higher cost. And the same is actually true for initial public offerings. So that's when a company goes on to the stock market for the first time. The same thing is true. If you have a lot of demand you can raise more money at a better price. So this is the reason that it's so important to look at primary market investments as those in which you'll have the most direct effect. 

And I like the way you phrased that Rick, because it's a two-parter. One is that probably there are certain companies you should be denying debt to, as in you should not be participating in new issues for those companies. But what you're talking about too is the pressure that you can actually put on at that moment, the kinds of engagement that you can have when a company is looking for new cash. That's a lot more leverage than you might otherwise have. 

And the other big lever as an investor, let's say that you retain shares in this company that you want to change the behavior of, and you've denied debt to that company. Well as an owner of the shares, there's been a huge focus on shareholder resolutions. Tons of those get filed every year, and they tend to be disproportionately about environmental or social issues. So they kind of get a lot of the attention of the ESG crowd.

Rick Ferri: Let me circle back to something I said before. If you're excluding these companies from your portfolio then you have no ability to put in a shareholder resolution. So it seems like it's counterproductive to not own the stock of the company if now you have no say in the company. 

Ellen Quigley: Yeah, exactly. Unfortunately the skepticism should stretch a little bit further. I now am not sure if shareholder resolutions are that effective themselves. There are better tools available to investors in a company. So just to say quickly why shareholder resolutions may not always be the best way to go, they tend to be about disclosure only, and that goes back to the philosophy of ESG, by the way – because ESG is all about trying to identify the risks to your portfolio so that you can stock pick more effectively, basically – so the disclosure of risks is what's useful to someone with that mindset. But disclosure itself can't be meaningfully connected to actual real world outcomes. There are quite a few studies on this and it's difficult to conclude from those that there's this straight line between improved disclosure and improved environmental performance, say.

Rick Ferri: Are there any other tools, big tools available to investors?

Ellen Quigley: Yeah  I've left the best until last, I guess, which is that if you vote against the re-election of directors that is probably the greatest power available to an investor in a company. And there aren't enough studies on this, I will say, and we need more research on it, but it does look like you can start to see some responses at the company level long before you actually win that vote because, and this the idea behind it, that very high status individuals who tend to serve on boards are personally embarrassed if they have votes against them, even to the tune of 10% or 20%, that would be quite a huge embarrassment to a high status individual. And you do tend then to see greater company level responses to that.

And if you think about what could be deployed in that regard on on climate, you could start to imagine that you could do something across whole sectors, saying here is an objective standard that's set by science and here's what would have to happen for us not to vote against your directors. And do something that applies to a whole sector so that there isn't a disadvantage to those who are decarbonizing on schedule say.

It's all about voting against directors and denying debt. If I had to pick two two tactics as a universal owner it would be those two things because they are they're the sharpest tools in the toolbox.

Rick Ferri: Ellen, what type of progress do you think is being made in the industry, in the investment management industry, towards this universal ownership concept.

Ellen Quigley: It's really interesting – I mean I have to give a depressing response, which I'm sorry to say, I think we're just we're not there yet at all. People are still in, at best, an ESG mindset and I'm hoping that we can see a leapfrog frankly. Because of the pandemic we have a greater understanding of systemic risks, an instinctive understanding of systemic risks. And I'm hoping that that will allow us to go straight to universal ownership instead of passing through ESG.

But I also have concerns about the conflicts of interest of the very largest fund managers which are trying to bid for the business of the pension funds of these big companies that are contributing externalities to the system. So I find it very unlikely that they are going to be the ones to lead the charge. And in fact, that has been borne out in terms of ESG adoption as well. My hope is squarely on pension funds, potentially some sovereign wealth funds, and endowments, foundations etc. I think that's probably where we're most likely to see that leapfrogging towards universal ownership. 

Rick Ferri: Well it's circling back to my ESG fund argument here in the United States where neither one of those are being utilized by ESG funds here in the US. You don't have any voting power. The weak one, the resolution if it even works, you don't even have that option. You don't have the option to vote out board members that may have a different viewpoint. And since you're just trading equity or not trading equity on the exchange in the secondary market, and these funds are not involved in the primary market. 

So there's really nothing of all of your research that actually shows that it might work. Let's talk about one last thing and that is government involvement. In your paper you're very specific to talk about one way you could really make change is through laws and regulations. From an ESG investing standpoint I mean maybe there is something going on here in the United States where politicians are becoming more aware that a lot of people are investing via ESG. So maybe they're becoming more aware of this, and maybe that is influencing at least what they talk about in Washington. Could you talk about, as far as from the investment level to the government leve, how does that shift take place? 

Ellen Quigley: I haven't seen any studies on this so I just want to leave open the possibility that it can help to provide support for government legislation. If people see that people are willing to put their money where their values are, whether or not that's misguided or not, as you and I have discussed, that who knows, that could contribute to a politician's level of comfort with enacting legislation in line with those revealed beliefs.

Rick Ferri: I'm trying to actually give some reason for people to invest in ESG here in this country who want to, without slamming them too bad here. Saying well look, even though it's not doing anything for your portfolio, maybe by investing this way, maybe it's in the media, you've got fund companies creating ESG funds left and right using all different things. I mean it's in the news and therefore it's getting the attention of politicians and is that having some effect?

Ellen Quigley: Yeah, I think it probably is. Again I don't have studies on this so this is just an opinion, but I think it's unlikely that you would see this level of media coverage of a phenomenon without its having any effect on both company practices and politicians willingness to enact legislation in line with it. And I think we are increasingly seeing companies kind of flailing about trying to figure out how to maximize their ESG scores and so on and so forth. By the way I find ESG scores to be problematic as well but I think it's unlikely that you would see this level of interest in a phenomenon without it having those larger effect.

Rick  Ferri: Well I'm just trying to come up with the reason why people would invest in ESG funds in this country. So that might as well be something that we can hang on to, maybe, maybe it's making some sort of a political impact, maybe.

Ellen Quigley: Maybe.

Rick Ferri: Well Ellen, thank you so much, greatly appreciate your time today and  your work that you're doing and I wish you all the luck in the world.

Ellen Quigley: Thank you so much Rick, and it's a real pleasure to to talk to somebody who instinctively gets this. 

Rick Ferri: Well, thank you. This concludes this edition of Bogleheads on Investing. Join us each month as we interview a new guest. In the meantime visit Boglecenter.net, Bogleheads.org, the Bogleheads Wiki, Bogleheads twitter, listen live each week to Bogleheads Live on Twitter Spaces, the Bogleheads Youtube channel, Bogleheads Facebook, Bogleheads Reddit. Join one of your local Bogleheads chapters and get others to join. Thanks for listening.


About the author 

Rick Ferri

Investment adviser, analyst, author and industry consultant


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