Why your “Green” fund might just be a lump of coal wrapped in expensive paper.
Santa Claus was the original ESG (Environmental, Social, and Governance) investor. He maintains a strict (checks it twice) database of global citizens, performs due diligence on their behaviour, and engages in negative screening (the Naughty List) and positive allocation (the Nice List).
However, if Santa used modern Wall Street “Ethical Funds” to run his operation, Christmas morning would look very different.
Before we dig in, let’s connect our analysis of this year’s ethical investing landscape to why your portfolio might need a visit from the Ghost of Christmas Past.
1. The “Green” Wrapping Paper
We have written extensively about Ethical Snake Oil. The financial industry has realised that if they wrap a standard investment product in green paper, they can charge higher fees for it.
Many Ethical Funds simply take the S&P 500 and remove a few obvious villains—tobacco, gambling, and perhaps thermal coal. You are paying premium fees for a “lite” version of their standard portfolio.
Maybe ethical funds should be a little more ethical in the way they charge fees?
2. Peace on Earth… Through Firepower?
Christmas is about Peace on Earth, but the geopolitical reality is more complex. In our piece on War & ESG, we analysed the massive shift caused by the Ukraine crisis.
Historically, weapons manufacturers were automatic entries on the Naughty List. But if a defense company provides the Javelins that stop an authoritarian regime from destroying a sovereign democracy, is that unethical?
- The Dilemma: Does the Social good of protecting freedom outweigh the negative of manufacturing weapons?
- The Reality: Standard ESG funds blindly exclude defense. If you believe defending democracy is ethical, standard funds are failing you.
3. The Political Dinner Table Argument
Just like a tense family Christmas dinner, ESG has become political. We asked Could Trump be Right about Ethical Investing?
The argument isn’t about whether pollution is bad (it is). The argument is about Fiduciary Duty. When fund managers prioritize “Woke” metrics over financial returns, are they stealing from your retirement?
The “Naughty List” is subjective. One investor’s “Social Justice” is another investor’s “Corporate Overreach.”
4. When Christmas Cheer clashes with climate change
Most ethical funds are “one ethics fits all”. Maybe you want to do something in your investments about climate change, you are probably going to end up ditching beer and wine as well.
And that’s where nuance is lost. Not everything is black and white.
The question: can you enjoy a beer and still do something about climate change?
5. How much is it going to cost you in returns?
We asked this question here. The answer to this is surprisingly difficult.
Say investors knew for certain that tobacco shares would underperform. Then, sophisticated investors would simply short tobacco shares, go long everything else and make a riskless profit.
Secondly, we find that when we let investors choose their own exclusions, most only choose one or two sectors. If you are only cutting out a few shares, then the performance difference is often negligible.
My best estimate is that if you believe markets are relatively efficient, then the expected performance hit is pretty close to 0%. It won’t be, but it is just as likely to be positive as it is to be negative.
The Solution: Be Your Own Santa
The lesson from all our research is that Ethics are personal.
There is no universal “Nice List.”
- Some investors want to screen out Nuclear energy; others see it as the solution to climate change.
- Some want to screen out alcohol; others own a winery.
The solution is to move away from “One-Size-Fits-All” ethical funds. Through Direct Indexing and separate managed accounts, you can build a portfolio that reflects your values, not the marketing department of a large bank.
Merry Christmas from the MB Fund team. May your returns be high and your fees be low.
Post Script: Five steps to making an ethical difference (in order)
- Make a donation. Are you trying to help or are you trying to make money? If it is the first, then by donating, you can feel good straight away. You get a tax deduction upfront – rather than waiting to book a capital loss when you sell shares! Donating directly to companies is not generally tax-deductible – but I’m guessing if your cause is ethical then there will be industry bodies that are tax-deductible.
- Lobby regulators or legislators. Not owning (say) gaming companies is a far less effective form of protest than lobbying for political change in how gaming companies target problem gamblers.
- Buy (or boycott) the product yourself. Most companies want more customers rather than more shareholders – and the ones that don’t, you shouldn’t be investing in.
- Buy shares from the company in a capital raising. That way, your money will actually be used to fund the company’s expansion or research and development.
- Buy (or sell) shares on the market. This is the least effective way to help the company. All you have done is transfer money to another investor.