The case for long/short ESG investing
Earlier this year, Bloomberg Businessweek published a scathing critique of the ESG investing world, especially ESG ETFs.
The article points out that while large investment houses discovered a gold mine by marketing ESG funds to millennial investors seeking a worthwhile cause to back, the “greenwashing” required to make these ETFs investable has resulted in ESG criteria so broad and all-encompassing that ESG ETFs find themselves invested in the likes of Phillip Morris, ExxonMobil and Coca-Cola.
To us, the idea of a passive socially responsible fund is oxymoronic (if not moronic). Even more incomprehensible is the idea that socially responsible funds must be long-only.
A look through Morningstar’s top 10 ESG funds of 2017 list confirms the broad hypothesis – the methodology that most investment houses apply to ESG investing is an exclusion criteria. So if you don’t support cigarettes, the funds cannot buy them. Same for alcohol, gambling, arms dealing or environmental exploitation.
These funds are limited by a mandate that reads something like, “The fund is not permitted to invest in securities issued by companies assigned the Global Industry Classification Standard (GICS) for the tobacco industry.” Others have slightly broader descriptors, and some even have caveats to say investment performance may be affected by taking ESG factors into consideration.
Such exclusion criteria also lend themselves to easy screening methodologies, hence the ease with which passive ETFs are created.
Both of these approaches sorely shortchange investors. After all, the opposite of “support” is not “not support”, it’s “oppose”. Going passive and “not investing” in companies with poor ESG isn’t as bad as investing in them, but it’s a long way from making a statement of conviction. Similarly, “not irresponsible” is hardly the same thing as “responsible”.
Being passively responsible actually makes very little sense. Moreover, simply applying sector classifications allows many things to slip through the gaps. A consumer staples company (not excluded) may be making highly sweetened drinks for children in Southeast Asia, while a defence contractor (excluded) in Turkey may be creating jobs and driving independence from foreign arms imports, arguably a positive externality for the Turkish economy.
So here’s our take on ESG investing. We believe poor ESG makes for poor business in the long run, and is similarly a poor reflection of the management of a company. Specifically, ESG is a driver of long-term fundamental performance. As such, ESG should not be a specialised investment class that's set aside and labelled as such (implying that every other investment we make is by extension “irresponsible”). Nor must the criteria for ESG be a box-ticking exercise. The role of the investment manager is to understand each business and evaluate it for what it is, according to the spirit, rather than the letter, of the mandate.
Therefore, ESG considerations form a core, natural part of our investment theses. Bad management sneaking cash out of the business makes for perpetually poor profits; irresponsible farming practices leading to environmental sanctions leads to fines and losses; unhealthy products leading to a widespread pushback by consumers precipitate stagnating or falling revenues. These are the very stocks that make for great short positions – they provide protection for the rest of the portfolio and carry optionality for big moves to the downside once consequences come back to bite. Long-only investing misses out on these opportunities by placing an exclusion criteria – again, “not long” isn’t the opposite of “long”; “short” is.
As economic agents in a market, our role is to seek out the fair price of assets. Simply avoiding them doesn’t solve the mispricing, but taking an active short position in these stocks in anticipation of a correction downwards does. One caveat – we’re not in the business of naming and shaming.
That’s the case for long/short socially responsible investing: because it’s not only about supporting the good guys, it’s about helping those that misbehave correct their ways via market incentives. Responsibility is active in both directions, not passive and one-sided.