The ESG Bubble Is Bursting
Politicizing investment decisions was never a good idea—especially for public pensions.
The current market and political turmoil have now thrown cold water on two investment trends that never made much sense: cryptocurrency, and environmental, social, and governance (ESG) funds. But while crypto’s future remains unclear, ESG is losing fans by the day. Even some who like the idea of investing in pet causes are expressing concerns that ESG doesn’t live up to its principles and is “green-washing” corporations that do, in their estimation, bad things.
The bigger challenge, however, may come from Republican lawmakers seeking to get public-pension money out of ESG funds. Florida recently banned managers from considering ESG requirements for the state pension fund. The attorney general of Arizona has argued that public funds should not be invested in political causes.
ESG funds claim to invest in companies that meet environmental, social, and governance goals. This means that they invest only in companies that do good things for the environment—like using clean energy or avoiding pollution—and that employ fair labor practices, pay their workers well, and are committed to diversity not only on their staff but also on their corporate boards.
It’s fine, of course, for individuals to invest only in corporations that reflect their values. The problem is that what counts as virtuous is rarely cut and dry. Are oil companies good or bad? Fossil fuels may not be good for air quality or greenhouse-gas emissions, but they empower economic development around the world. Oil companies are among the biggest investors in renewable energy. Choosing companies that reflect your values turns out to be a lot of work, and often requires you to take strong personal stands on various issues. The idea that you could outsource this process to a fund manager at BlackRock was always absurd.
What ESG really offered was an opportunity to bring politics into investing, because deciding which companies meet ESG standards is a value judgment, and that means making a political choice. So the idea of public-pension funds investing in ESG—an inherently political concept—was always troubling. In 2018, at least $3 trillion of public pension money, or about a quarter of the market, was invested in ESG funds. This is a problem for two reasons. One is that it means lower returns. As Cliff Asness points out, a constrained portfolio will never return the same amount as an unconstrained one. When the economy was growing, ESG funds appeared to do as well as, or even better than, value-neutral index funds. Now the market is turning, and ESG funds are underperforming. Investors must assess funds based on how they perform in all markets. And when it comes to public pensions, the taxpayer is the one who has to foot the bill for underperforming funds.
ESG investing is also inappropriate for public funds because it is political. Why should taxpayers bear the cost of funds that underperform because they reflect political beliefs that not everyone shares? To some extent, this already happens: investing public-pension money in local, politically favored projects is popular, but it also leads to terrible deals for taxpayers and should not be scaled into public markets.
Bloomberg argues that the GOP is coming for ESG funds by calling it woke investing. Regardless of whether you support ESG values, this shows us why values-based investing was always a bad idea. Not everything needs to be politicized— especially not public-pension funds, which are already underfunded and don’t need more waste.
For a while, ESG looked like a good bet, and values seemed cheap. In a down market, though, ESG’s true cost is starting to reveal itself—and in a more volatile, energy-scarce market, it will only get more expensive. Politics aside, few people or fund managers will tolerate funds that underperform, and this may be the real reason ESG funds have peaked.
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