Saving the World is Hard

The cut-throat endeavor of extracting as much profit as possible from as little investment as possible now faces demands to improve the fate of humanity at the same time. Objections are natural, but the hardest of hard-nosed investors should relish the challenge of including environmental, social, and governance practices in their analysis. Above all, it’s not really that much more complicated than what they already do, and it means they won’t soon be replaced by a computer algorithm.

Maybe just as important, it allows them to tell their children that, amid their challenging bare-knuckle efforts to choose winners over losers, they are doing their part to make the world a better place. Investment managers may not rank with nurses and math teachers in their contributions to the greater good, but it’s still a pretty worthy career if you can help drive global prosperity while encouraging progress on the goals society shares.

Free markets and profit motive have been at the heart of economic progress since long before Adam Smith’s “invisible hand.” But outside of introductory economics textbooks, people apply all kinds of criteria to financial decisions far beyond securing good value or a reasonable return. They avoid the restaurant where they find the bartender’s politics abhorrent—even if the food’s a bargain. They boycott the fashion line that buys from sweatshops—even if the jeans are a steal. What’s so unreasonable about framing investment decisions in much the same way?

What seems like a recent fad is hardly new. Values have been shaping financial decisions since the world’s great religions began condemning usury. America’s Quakers banned investments in the slave trade, and more modern investors developed their own list of exclusions they deem sinful.

But it may be easier to address the legitimate questions about ESG one at a time.

How do you prioritize among the E, the S, and the G? My favorite hypothetical challenge is the racially diverse management team that donates half its profits to orphans from operating lignite coal mines. It’s legitimately hard to know if your investment should support diversity and underprivileged children at the expense of additional carbon emissions. But investment teams make difficult trade-offs all the time between, say, currency risk and uncertain margin improvement. There are very few clear choices in any portfolio, which is precisely the advantage of a portfolio of choices.

Is my S the same as your S? There is a long list of social concerns in the world and very little agreement on which are most pressing. But like Justice Potter Stewart’s famous line about pornography, good investors recognize socially responsible corporate managers when they see them. For now that should be enough.

How do we measure any of this? These are real challenges that the asset management industry has only just begun to tackle. But anyone who has worked through the Lehman Brothers failure will admit that AAA credit ratings didn’t quite measure balance sheet strength as we had hoped. Ratings along E, S, and G dimensions have a long way to go and will always be imperfect. But this is an area active investors should embrace, since passive vehicles can’t possibly make the nuanced judgements that are so crucial.

Should investment reward effort or achievement? This is perhaps most tricky of all, as investors aren’t necessarily sure themselves if a heavy polluter trying to get cleaner is worth encouraging over a competitor that is setting the industry standard. Again, investors will differ on this choice just as they do on the merits of value vs. growth stocks. The important part is that the managers are clear about what they do and why.

Aren’t all these concerns better left to governments? It’s obvious that engaged governments are a necessary part of solving these questions, but they may not be sufficient. Even if they were to legislate precisely the mean preferences of their voters across these issues, investors and markets provide an important policing and enforcement function that regulators and courts cannot.

Don’t investors give up returns when they include ESG considerations? Some ESG investors claim they can actually deliver higher returns, often suggesting that avoiding polluters helps minimize risks of loss. So far, at least, the academic research on the question is far from clear, but nor is it clear that these strategies deliver significantly worse performance over time.

Do ESG investment choices really drive up the cost of capital for “bad” firms? If that’s how it works over time, then the bond returns of “good” ESG firms will be lower. But much more important than the discipline of capital costs is the engagement from shareholders, ratings agencies, and financial journalists who force companies to explain how they are improving their practices. Even when they are prone to exaggerate, they can’t hide bad behavior forever and their efforts to respond to these concerns are what create better business models in time.

Of course, capital discipline and profit motive alone can do a lot to improve the condition of humanity, and naturally there will be no progress on environmental, social, and governance issues without good laws and vigilant regulators. But doesn’t humanity need all the help it can get? At least, isn’t that what our children will ask?