For those who subscribe to the view that there’s an equal and opposite reaction to every action, as Isaac Newton’s Third Law states, then the rise in anti-ESG products might not come as a surprise, writes Sparrows Capital’s Mark Northway (pictured).
Regardless of how familiar you are with the English mathematician’s work, this burgeoning trend of asset managers purposefully targeting sin stocks as a response to the recent popularity of ESG investing is a trend worth scrutinising.
Last year, Strive Asset Management raised $315m in less than a month via its US Energy ETF (DRLL), with executive chair Vivek Ramaswamy stating that his firm was “representing the voices of a lot of everyday citizens who have their money invested by other asset managers [that] advance social and political agendas that [the client] does not agree with”.
And another firm in the US has proposed an index fund called BAD, which will focus on betting, alcohol and drugs companies.
While these two examples might seem insignificant in scale compared to the entire investment universe, the rising din against ESG investing raises a fundamental issue for investors.
Identifying the returns driver
At the root of all this is whether environmental, social and governance investing – or ESG – is, in itself, something that genuinely impacts investment returns.
There’s been heated debate about this, particularly during the Covid-19 pandemic when notionally ESG-friendly stocks appeared to be outperforming their nefarious rivals.
But there are potential explanations that are more evidence-based for why this outperformance occurred, and equally for why ‘sin’ has long outperformed virtue.
In the case of ESG stocks, it’s probably fair to say, until the recent past, they weren’t as frequently sought by investors. This means that their cost of capital was probably higher, thus they had to issue shares at a lower price, making investors view them as more risky.
This meant returns were probably healthier for those who had sought these businesses out, and then when other investors began to notice, momentum began to take hold.
Fast-forward to the pandemic, and with virtue thoroughly ‘en vogue’, the flurry of investors seeking so-called ‘good’ investments out meant their valuations rose faster than their less virtuous rivals.
But this means that momentum – which we deem an investment factor that can genuinely impact returns – was the driver for ESG outperformance in recent years, and not ESG itself.
And that’s important when it comes to this new spate of sin-focused funds.
Just as ESG stocks may have had a high cost of capital a decade or so ago, sin stocks such as tobacco and alcohol suffered the same impediment as a growing number of investors wanted to exclude them from their investment strategies.
However, as noted by Dimson, Marsh and Staunton, a higher cost of capital might not always be a bad thing.
“A heightened cost of capital represents an elevated expected return,” the trio said.
“Choosing to exit ‘sinful’ stocks can cause them to offer higher returns to those less troubled by ethical considerations.”
To put this into numbers, Dimson, Marsh and Staunton found that in the US, tobacco stocks, on average, outperformed the overall market by 4.6 annualised percentage points. And in the UK, alcohol stocks beat the overall market by 2.2 annualised percentage points.
And another study published in The Journal of Portfolio Management showed that over a 37-year period between 1970 and 2007 across 21 different countries, gaming stocks outperformed their overall home country stockmarket by 26.35 annualised percentage points, followed by tobacco (14.71 annualised percentage points), adult services (9.96 annualised percentage points), and alcohol (5.57 annualised percentage points).
So should investors flock to these anti-ESG products?
Conscience versus profit
In short, we would say no. This is because this debate is effectively assuming that ESG is a factor, whereas we would argue it is a filter.
This means rather than ESG having a fundamental impact on investment returns, investors are making a subjective choice, based on conscience, to select stocks from a smaller universe than the broader market.
Recognised factors, such as value, small cap, and momentum, are based on academic studies that reveal certain sub-sections of the market have persistenly experienced higher returns than the broader market.
Investors must ask themselves whether they are investing for their principles and are prepared to accept a potentially diminshed risk/reward profile, or accept that in an unfiltered investment universe, they may have companies in their portfolio that don’t align with their principals.
Purely seeking out sin stocks at the expense of all others would – in our view – be an equally conscience-based decision rather than an evidence-based one that would have an impact on the risk/reward profile of a portfolio.
Constraining your investment universe solely to sin (or solely to ESG for that matter) could mean you miss out on opportunities that investors who spread their bets across the whole market benefit from.