ESG investing may be in the early stages of a bubble

The asset management industry has been struggling for a while, but one category continues to attract assets: ESG, which screens companies for environmental, social and corporate governance factors. Put another way, it seeks to identify companies that strive to do the right thing. ESG-driven assets have now reached $40-trillion globally, which seems to have accelerated during the pandemic.

This turns on its head Milton Friedman’s premise that companies should try to pursue profit above all else and in that pursuit will accomplish good as an externality. Though ESG promoters say that doing the right thing and making money go hand-in-hand, the current thinking says that making money through investments is incidental to doing good.

In recent years, ESG-related investments have consistently outperformed their counterparts. That, however, could be an accident — many ESG funds invest heavily in tech companies, and tech most likely is rallying for reasons that have nothing to do with ESG. Many ESG funds exclude fossil fuel investments, but fossil fuel investments could also be doing poorly for reasons that have nothing to do with ESG. Look closely and it appears that ESG is just another old-fashioned stock market bubble.

ESG has become something of a self-fulfilling prophecy, driven entirely by liquidity and flows. Global ESG funds experienced inflows of $45.7bn in the first quarter of 2020, while the broader fund universe sustained outflows of $384.7bn, according to Morningstar. The sheer magnitude of these flows can drive asset prices in different directions and create the appearance that ESG is working as a strategy.

What’s interesting is that ESG investing is having its intended effect: it is raising the cost of capital for “bad” companies and lowering it for good ones. If this continues, it just might result in the disappearance of the fossil fuel industry. As a libertarian, I can’t say I’m sad about this — this is a better, market-based way of doing it than any top-down edict. But it’s probably a short-lived phenomenon.

I think that ESG investing is in the early stages of a bubble, which means it probably has a few years to go before reaching sublimely ridiculous levels. Tech stocks just had a blow-off top, while ExxonMobil just had its worst 30-day period in history.

We are starting to see products that are almost comical in their attempts to avoid energy, like SPYX, the new S&P 500 ex-fossil fuels exchange traded fund (ETF), which combines the S&P 500 index with ESG. There’s a lot of hype and promotion, which usually crops up in bubbles.

One of the big criticisms of ESG is that the criteria for determining which companies are trying to do the right thing are overly broad and subjective. Each ESG ratings agency has its own standards and weights for environmental, social and governance factors. It’s alarming that billions of dollars are being allocated subjectively when everything else in the financial world is quantified.

Last year, I wrote about the idea of constraints and that investment managers with constraints cannot be reasonably expected to outperform those without them. ESG managers are the constrained investors; they must exclude certain companies. The theory is that they must underperform over time. It hasn’t worked out that way yet, owing to the magnitude of the flows.

I believe that ESG is nothing but a passing investment fad, not unlike smart beta, the Brics, structured products or any of the myriad market bubbles over the past 25 years, small and large. High-performing strategies attract sponsorship. When the high-performing strategy becomes a low-performing one, that sponsorship will disappear — and investors will go back to companies that care about making money again.

In the midst of such a fad, it is tempting to believe that we’ve entered a new paradigm, but that is never the case. The stock market will do what the stock market does best: punish late entrants and reward intrepid contrarians.