The hidden costs of feel-good stocks

The hidden costs of feel-good stocks
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WINNIPEG – The stakeholder-shareholder debate in finance has narrowed down to a false dichotomy between good capitalism and bad capitalism.

Good capitalism means funding green energy to fight global warming, while bad capitalism means investing in fossil fuels, tobacco, or other “sin stocks.”

However, the economic downturn should be a wake-up call to investors regarding the hidden costs of feel-good stocks: lower returns, higher retail prices and job destruction.

The driving force behind moral investing is a new class of criteria known as environmental and social governance (ESG). This involves evaluating a company’s operations according to a vague set of subjective principles such as limiting carbon footprints and promoting diversity.

Proponents claim that socially responsible investments benefit all stakeholders, especially shareholders who enjoy superior returns. Critics counter that ESG can’t outperform an unconstrained investment approach and is a disservice to investors.

ESG oversimplifies the world and capitalizes on an ideological homogeneity to push a social agenda. Tapping into people’s cognitive biases and desire to do good, the lofty rhetoric of ESG distorts companies’ goals by politicizing corporate behaviour.

One may envy the profits of businessmen, but in a market economy, profit is a solid and illuminating metric. It reflects value provided to consumers and holds executives accountable to performance standards.

The lack of strong fiduciary standards and the insertion of vague goals, such as racial and gender diversity, result in skewed performance measures. There’s also no expert consensus on which firms have credible ESG credentials.

ESG undermines itself, according to Vincent Deluard of INTL FCStone Inc., by rewarding alarming corporate behaviour. Companies with few formal employees and offices fare well when graded against ESG criteria, as they typically have small carbon footprints. Allocating capital to such companies exacerbates underemployment – a hefty blow to deliver during this trying economic recovery.

Considering the vague, inconsistent ESG principles and lack of a clearly defined, agreed-upon ESG definition, many may be baffled as to how it has gained such popularity.

In Canada, eight pension funds managing a total of $1.6 trillion have called on corporations to increase ESG disclosures to aid in investment decision-making. The group includes the all-powerful Canada Pension Plan and the Ontario Teachers’ Pension Plan; both have mounting unfunded liabilities that put them in no position to play games with assets.

In contrast, the U.S. Department of Labor has proposed a rational rule that would prevent most employee-retirement plans from choosing ESG investments. The department stated they’re not in the best interests of investors and that fiduciaries shouldn’t sacrifice returns or undertake greater risk to push ESG policy goals.

To better understand the ESG craze we can look to insights from behavioural finance. Affinity bias is a cognitive bias that distorts the information processing and emotions of investors, causing them to prioritize the buying or selling of a security to reflect their personal values. By getting caught up in how others will perceive them, investors fall prey to this bias and make uneconomical decisions.

Instead of focusing on presenting objective facts, ESG funds tend to resort to storytelling. It’s no wonder that ESG is most popular among millennials and generation Z. In a 2019 YouGov poll, 70 per cent of U.S. millennials said they would vote for a socialist.

Investors seeking to contribute to helping others should look to the burgeoning field of effective altruism. While ESG corrupts business by entangling it with emotions and non-profit-related metrics, effective altruism applies economic theory and business analysis to charitable organizations.

This framework improves efficiency and maximizes the impact of every charitable dollar donated. Even though charitable giving is more subjective than investing, there are actually better and more standardized metrics for charity evaluation than there are comparing ESG funds. Givewell, a non-profit research organization, evaluates and rates charities that maximize the impact of additional donations in terms of lives saved or improved.

The fundamental economic concept of opportunity cost, because it’s implicit, is often overlooked in charitable giving. For example, a lawyer who can charge $600 an hour but decides to spend an afternoon sorting cans at the food bank to give back has made an uneconomical decision. Instead, he could have earned those $600 and donated them to the food bank, resulting in a far greater impact. Similarly, investing in strong-performing stocks and donating the proceeds rather than investing in mediocre ESG stocks would likely have a larger impact.

By negatively impacting financial returns, ESG is a disservice to investors, many whose subsistence depends on performance. It is also a disservice to lofty goals that could be reached more effectively by direct methods.

Most puzzling of all, ESG is perhaps the explicit delegation of moral authority away from individuals or government. Leaving moral decisions to CEOs and money managers with conflicting agendas invites disaster.

The Roman historian Sallust said of Cato, “He preferred to be good, rather than to seem so.” ESG investing may make you feel good but it rarely does good. A company’s job is to deliver cost-effective goods and services, not to legislate the morals of our society.

By Caitlin Rose Morante

Caitlin Rose Morgante is a research associate with the Frontier Centre for Public Policy, a Boston University economics student, and currently enrolled in an internship at Econ Americas.

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