Profits Not Politics | Seeking Alpha

When I was a broker in the 90s there were a couple of mutual funds that followed “socially responsible” investing strategies. At the time the vast majority of companies just focused on their business and didn’t pay heed to any social issues, so the universe these funds had to choose from was sparse. Not surprisingly, the performance suffered and these funds only appealed to a small group of investors, for who investing according to their values mattered more than making money. Fast forward to today and the landscape has changed significantly. Now, socially responsible has become ESG, which stands for Environmental, Social, and Governance. I am not sure what came first, the chicken or the egg, but now you have a number of rating agencies that rate companies on ESG standards. You also now have a number of ETFs that use these standards in picking companies. It hasn’t stopped there however. The major ESG ETF companies, namely BlackRock, Vanguard, and State Street, have come under scrutiny for using the proxy process to pressure companies to adopt ESG standards. Remember, through their fund holdings these companies are the top shareholders in a number of companies. You have also had a number of states use ESG standards in picking investments.

As with anything that takes off like this you see backlash. Critics say these companies and asset managers are using ESG to push policies that they couldn’t get through using the ballot box. In response to this pushback you have seen BlackRock talk about not using the term “ESG” as it has become polarized and you are seeing states push back on ESG in their investments. You are also seeing all sorts of proposed legislation regarding these issues. Other critics, such as myself, would argue that investing should be solely about making money, not about trying to change the world. There are other valid criticisms however, first off is what constitutes ESG? Different raters use different standards. For example you recently had Elon Musk bashing S&P Global for giving Tesla a lower ESG score than cigarette making, Phillip Morris. Then you have the largest ESG ETF The iShares ESG Aware MSCI USA ETF (ESGU) with a 4.64% exposure to oil stocks vs. The S&P 500 which is about 4.74%, hardly much of a difference.

At the end of the day however, it comes down to performance. I looked at the largest ESG ETFs vs. the S&P 500 over the past three years 9/8/2020-9/8/2023. I decided to use that period as I think when ESG first became popular you had a scramble to buy high ESG rated stocks, now that there is some backlash I would surmise that a high ESG rating doesn’t give a stock a premium. Here’s what I found:

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Interestingly they all underperformed the S&P 500. I know there could be a lot of valid criticisms, the S&P was helped by an overweight to the Magnificent 7 stocks (Tesla, Apple, Nvidia, Microsoft, Alphabet, Amazon, and Meta), or the period was cherry picked. However, I would argue that these results are interesting to say the least. We have also recently seen some high profile issues with companies that have decided to pursue controversial social issues. Bud light, Target, and Disney come to mind, and we have seen those stock prices suffer accordingly.

As part of the backlash we have seen a few ETFs pop up the espouse conservative values. I took those ETFs and did the same analysis. I couldn’t go back quite as far but I got to 10/29/2020 to 9/8/2023:

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Another ETF, YALL has done quite well but has a less than 1 year history. Interestingly, these two ETFs have significantly outperformed the S&P 500, with MAGA crushing it. Yet, they have not garnered much in the way of assets. There could be a number of reasons for that, first off, they don’t have the marketing muscle of a BlackRock, State Street, or Vanguard. The ticker symbol MAGA could also be tough for a few people to stomach. However, the data seems compelling on the surface. You have seen one firm in the space, Strive, gather over $1 billion in assets, but their approach is different. Instead of excluding stocks, they seek to battle the big guys in the proxy process, so as far as this analysis is concerned I treat them as a separate beast.

What I take out of this is a thesis, and that is that I would expect companies that solely focus on profits and are politically neutral should outperform companies who devote time, effort, and money towards social causes. I am aware that in my example above that conservatively focused companies have shown some outperformance, but I am also aware that MAGA has a 13.52% exposure to energy stocks and would suspect an attribution analysis would show a significant determinant of outperformance came from that. Obviously, that thesis holds true on the small sample size above with Bud Light , Disney, and Target, but does hit hold over a larger sample size? To test my idea I designed an index using Bita’s indexing software. I took the universe of large cap US stocks and picked out the companies in the lowest decile in the social part of ESG as I felt that is the politically active area. My guess is that just scoring poorly in ESG social scores isn’t quite enough, so I picked out the top 50 companies based on the quality factor and market cap weighted them (with a 7% cap so we didn’t end of with an index too heavily weighted). What I ended up with was quite interesting. I had thought the long term performance of my lower social score index would underperform as you were dealing with the popularity of ESG, but that’s not what I found. I used the iShares Core S&P 500 as a benchmark as that is coded into Bita. Over the 5 year period ended 9/7/2023 the index returned 78.47% vs. 68.95% for the benchmark. Over a 10 year period ended 9/7/23 it returned 288.59% vs. 220.98% for the index. That’s a 14.3% average annual return vs. 12.17%. It also outperformed the benchmark in 7 out of the 10 years. In 2018 the index was down 4.93% vs. the benchmark of down 4.49%, in 2020 the index was down 20.37% vs. down 18.65% for the benchmark, and year to date the index is up 15.97% vs. 17.79% for the benchmark. This naturally got me thinking if all I did was prove the quality factor works, so I did the same analysis without the low social scoring, so basically taking the large cap US companies and creating an index of the top 50 by quality. Over the same 10 year period my quality index returned 201.43%, much less than my low social score index.

I would suggest this is an area in need of further study. Over the past few years we have had a seismic shift in the asset management industry towards ESG. I would suggest that this has gone too far, not just from a political standpoint, but also from the potential of sacrificing returns standpoint. I think the data is compelling about the possibility of politically neutral stocks outperforming those that engage in politics. With everything in investing though, correlation doesn’t equal causation, you want to have a thesis that also makes sense. I believe this one does. Companies that only focus on profit should outperform those that divert time, money, and resources to politics.