Does ESG Investing Work?
To ride the growing wave of SRI, financial advisors need to deliver a nuanced vision of what socially responsible investing can and cannot do.
Part I: Diving into Divestment
Many in the investment community – particularly financial advisors contending with a shifting landscape – are just getting wise to the importance of socially responsible investing (SRI) and environmental, social and governance (ESG) factors. Since 2014, professionally managed investments in the United States deployed along SRI strategies has grown an aggressive 30% year-on-year by value of AUM, reaching a whopping one in four of every dollar invested.
And though many factors have contributed to this growth, client demand tops the list of drivers, according to a survey of money managers with over $4 trillion dollars in assets collectively under management. At the same time, healthy skepticism remains about the actual impact that ESG investments have on improving company practices, the welfare of the communities they impact, and the environment.
To provide insight into these dynamics, this post investigates a critical but controversial aspect of socially responsible investment: the impact, power and potential of divestment as a lever for social and economic change.
What is divestment?
Divestiture, the offloading of stocks or assets, is usually done when an investment has not been performing up to expectations. In social terms, it is also associated with an explicit refusal to support or participate in unethical groups or activities.
Take the current #BoycottAlabama movement, launched in response to the state’s proposed legislation to criminalize the provision of abortion by medical providers. Colorado’s Secretary of State has refused to authorize the spending of state resources on travel to Alabama, and Maryland’s Comptroller Peter Franchot called for his state’s $52 billion pension fund to divest from Alabama completely. “I can work to ensure that Maryland’s taxpayer dollars are not used to subsidize extremism,” wrote Franchot on Facebook.
Blue chip companies are equally important participants in this kind of divestiture activism. Paypal, Axa and Swiss Re have proven willing to pull out of massive commitments or outright blacklist business sectors misaligned with their social values.
But does it work?
One of the most common arguments challenging the effectiveness of divestment points to the stock price movements of targeted companies. The best-known historical example comes from apartheid-era South Africa, where economic analyses of public companies’ share prices throughout the divestment movement suggested that even social pressure at a global scale yielded only questionable impact on share price.
A shed ‘sinful share’ can only be sold, the argument continues, if there is a willing buyer at the company’s publicly traded share price, essentially constituting a process of re-allocation from value-minded investors to value-agnostic ones, and obfuscating any potential for downward share price pressure to act as a corrective for corporate behavior.
Impact: Market signals and cultural symbols
To help clarify if, how and when divestment movements are effective in the 21st century, it is instructive to look to bathroom bills and basketball.
In March of 2016, North Carolina’s state legislature passed the Public Facilities Privacy and Security Act – popularly known as the bathroom bill, limiting non-binary gendered individuals’ choice of public bathroom facility use.
Public condemnation, and scrapped investment plans from the likes of PayPal, Dow Chemical, and Levi Strauss & Co., swiftly hit lawmakers and companies in the state alike. They soon faced the prospect of an estimated $3.76 billion in lost business projected over 12 years. Equally shocking was the NCAA’s decision to boycott North Carolina stadiums for games scheduled between 2018-2022. In a state where college basketball amounts to cultural identity for many, this was unbearable pressure.
The impact: most of the bill was scrapped, and the North Carolina governor quickly unseated. It does not appear that this kind of unambiguous impact is limited to any particular issue, either: when Peabody, the world’s biggest coal company, announced plans for bankruptcy in 2016, it counted the divestment movement as one of the reasons it was unable to raise the capital needed to survive. As if to confirm the diagnosis, analysts at J.P. Morgan and Goldman Sachs have explicitly asserted coal divestment’s causal impact on suppressed Peabody share prices as well as the industry’s de-rating as a whole.
"[…] a growing number of investors and financial institutions have announced bans or restrictions on coal investments, […] which have in our view been a driver of the sector de-rating over the past five years."
The point that anti-divestment proponents seem to minimize is that cultural symbols influence and complement market signals. Their interactions are, however, complex, and they aren’t always observable in an individual company’s stock price. Let us also note that stock price represents only a very narrow view of economic impact, much less social impact. As the examples from the last few years demonstrate, however, when a divestment movement achieves cultural and political resonance, we observe convincing evidence of both short-term and structural impacts on the targeted investment environment. Financial advisors should thus feel confident affirming the economic and social impacts of divestment – whether directly observable in share price, other parts of the balance sheet, or the political arena.
Why such confusion and controversy around divestment, anyways? Let’s do a quick genealogy. Coded into traditional arguments against divesting is an assumption around the costs and risks associated with removing stocks or stock-picking in general. The rise of indexing and passive management further enshrined the idea that ‘smart money’ wears a veil of ignorance, reflected in the growth of passive trackers beginning in the mid-70s to 40% of today’s market.
However, these assumptions were built on a paradigm from a previous era. Dynamic custom indexing, powered by frictionless algorithmic trading, replicates indices by directly purchasing the underlying stocks. It thus enables customized diversification: the ability to break apart and rebalance a portfolio in real-time, ensuring tight tracking of the index, while creating opportunities to tailor investment strategies to an investor’s unique situation – or social values.
With the ability to invest ethically and achieve market-frontier diversification, investors can now have their cake and eat it, too. If a strategy tracking the MSCI World with a climate overlay tracks the index within 20bps, what’s the rationale for a strategy that carries Peabody? If you can get performance similar to the Russell 1000 without owning companies that own and operate prisons and detention centers, why invest in the Prison-Industrial Complex at all?
On the question of divestment, the burden of proof has shifted to detractors and naysayers. The question is no longer: “Does divestment work?” It’s “Why wouldn’t you?”
Investors can now divest along their values with a simple click
OpenInvest’s indexing technology allows investors to grow their wealth in alignment with the values that matter most to them, including gender equality, LGBTQIA+ rights, ethical supply chains – as well as tackle issues like fossil fuels, deforestation, and greenhouse gas emissions, among others.
Our Racial Justice cause, for example, allows any investor to tailor their investments to only include those companies who are transparent about their progress on diversity targets, and to divest from those that disproportionately pollute in communities of color.
TL;DR: Divestment is indeed a powerful lever for effecting social change, but is only one way to improve corporate behavior
In future posts, we’ll explore other ways socially responsible investing can move the needle to a more just society, including how proxy voting can influence corporate behavior and the influence of shareholder activism on company leadership.