ESG is Not an Investment Strategy

We keep seeing articles fingering ESG for the sub-benchmark performance of some socially responsible investment (SRI)-themed funds.

That’s like cursing the hammer for your sore thumb when you’re the one swinging it.

That the terms ESG and SRI have become so popularly confused is not just unfortunate; it is wrong, and this mistake can be harmful. It’s high time to disambiguate.

Here’s the difference: ESG is data. SRI is a strategy whose creators may reference, and rely on that data.

ESG is simply another tool in the wise investor’s toolbox: an inanimate object whose ultimate effect depends mostly on outside force and the intelligence guiding it.

Larry Swedroe claims that “ESG investing … can lead to less efficient diversification (due to screening out companies and even whole sectors of the economy).”

The SRI funds he references exclude not just companies scored low in ESG, but whole industries. Naturally, these exclusions disrupt the starting universe’s risk-return profile.

Under these circumstances, who can say whether the data itself bears any fault? A confident answer requires a test controlling for other variables.

For a start, how about testing an ESG-informed strategy without any exclusions. Apples-to-apples. How does that same universe of companies perform when cap-weighted, equal-weighted, or weighted using ESG scores? There’s your fair gauge of ESG’s impact on risk-adjusted returns.

If you’re playing along at home, you can run this test yourself. Pick an ESG data provider (for a trial period, if necessary), build a benchmarked portfolio, and backtest it. Go ahead, we’ll wait…

Are you back? Good.

If you’re as thorough as our research team, you’ve discovered something new. Maybe you’re seeing ESG with fresh respect. Maybe you even have some ideas how to put it to work.

Don’t yell at the hammer. Learn to swing better.