The State of ESG….Part I
At Constrained Capital we apply nearly 30 years of Wall Street experience to allow us a deep dive into ESG from all angles, digging into the complexities of the ESG investing movement and its evolution into the largest investment bubble of the past decade.
We’re going to talk about the current state of ESG, how we got here, and what it means for investors going forward. This is the first installment in a three-part series.
How Did We Get Here?
Wall Street has a classic pattern in product/theme development. It starts by creating cottage industries around new investing fads alluring investors with false promises of big returns and minimized risk. These products usually come with high fees and end up with weaker than expected returns.
Michael Milken and junk bonds. Lewis Ranieri and mortgage bonds. Those are some of the stories of the past that ended up as heightened risk moments in Wall Street history. CDOs, Ninja Loans were other chapters in the same story. Recall the GFC. Recently, Blythe Masters and blockchain saw an evolution into crypto and NFTs. All of these products created massive risks on Wall Street.
The disciples of these innovators spread to various Wall Street banks on hiring sprees to create high-margin products that could be readily packaged and sold. In the end, no one knows or understands the product like the originator. Each new iteration and expansion brought less skill and know-how, resulting in a greater misalignment of risk and a product that bears little resemblance to the original concept. These risks expand geometrically and become unmanageable. Bubbles build. There’s risk overload. Then systems blow up and reset.
The emergence of the ESG investing bubble is no different. There’s nothing new to “fad on Wall Street” leading to massive market risks. Constrained Capital studied the evolution from Socially Responsible Investing morphing into ESG. We looked at progression from the EU to Japan and to the US over the past decades.
What we found are deep inconsistencies in the ESG ratings’ agencies and the selection process by ESG funds. Consider the different “E,” “S,” or “G,” ratings for the same company within each different of the 10+ rating agencies as one example of many. AMZN has the biggest carbon footprint in the world. MSCI ranks AMZN in the middle at “BBB.” Bloomberg has AMZN “above peers” in emissions, despite that carbon footprint. Sustainalytics has AMZN in the “high risk” ESG category. 3 different agencies, 3 starkly different rankings.
Then we looked at AMZN’s weightings at various ESG funds. AMZN is weighted in ESGU (Blackrock’s ESG Aware Fund) at 3%, its 3rd biggest holding. In Putnam’s Sustainable Leaders Fund it’s a nearly 5% weight. Owning an ESG fund with AMZN is the opposite of “Knowing what you own.” This means heightened risk to holders of ESG funds as many would not be able to explain the ESG merits of AMZN.
MDLZ makes Oreos and Chips Ahoy, filling school vending machines with empty calorie items that are massive contributors to the epidemics of obesity and type II diabetes. It consistently scores in the middle of MSCI’s ratings and the bottom of Sustainalytics’ risk score, yet is a top 20 holding in Parnassus’ $2Bln Sustainable Equity Fund. BDX (Becton Dickinson) finds itself in the middle of most ESG scoring systems (BBB in MSCI, “medium” risk at Sustainalytics) yet is a top 5 holding (4%) in Parnassus’ Fund.
In sum: ESG portfolios are littered with these inconsistencies both at a ratings’ agency level and at the fund selection level.
Now from a macro perspective, consider the exclusion of nuclear energy producers. Nuclear is a clean and renewable energy source. (https://www.morganstanley.com/im/en-us/capital-seeker/about-us/news-and-insights/articles/the-nuclear-revival.html) Germany prematurely shut down their nuclear facilities and ended up beholden to Russia for current energy. Perfect evidence of massive increases in macro risk due to ESG investment guidelines and regulation. Russia knows ESG and used that risk dynamic to their advantage. In essence, they took advantage of capital constraints imposed by ESG on both the fossil fuel and nuclear industries to take advantage of Germany and the EU.
MIT called ESG investing, “Aggregate confusion.” Tariq Fancy (former head of Blackrock’s ESG investing) called ESG, “A dangerous placebo for the public.” Carl Icahn recently called ESG, “The greatest hypocrisy on Wall Street.” Earlier this year Elon Musk said, “ESG might be the Devil incarnate.” The world is waking up to the misdirection and inherent risk in ESG investing.
Cliff Asness and Aswath Damodaran have railed against ESG’s false promises. Asness said lower returns were a cost of being virtuous. Damodaran said that you cannot impose a universal “goodness” level and force everyone to comply. Their work underscores how we got to here and was a guidepost for Constrained Capital.
The sectors most influenced by ESG investing are the exclusions. The ESG “Orphans” as we call them. They have been under ESG capital constraints for more than a decade. Flows have been massively one-way into all sectors but six: Fossil fuel, nuclear energy, weapons, alcohol, tobacco, and gaming. The result has been malinvestment and misallocation into sectors that received excess flows (high valuations, all alleged ESG stocks) and constraints and less flow into others (lower valuations, the Orphans.)
The ESG bubble has been built up over time. The pushback has begun and the unwind of the excesses will not be immediate. It took a while for the industry build including regulatory/compliance infrastructure, the embedding of high fees and charges, and excessive employment for analysts. This will likely result in an equal amount of time on the correction, pushback, and unwind.
In Part II we will further address in more detail the current state of ESG. We will highlight more current news, the immediate impact felt by the ESG investing community, how many asset managers are digging their heels in and reiterating their misguided ESG stances. Part III will discuss how to position for what we see coming down the ESG pike and how to manage that risk.
For more up-to-date and live time ESG-related news, follow us on Twitter:
@ESGOrphan and @MarkNeuman18
Mark Neuman, CFA, CIO/Founder, Constrained Capital mark@constrainedcapital.com 917 658 9369
