Why Cliff Asness misses the point when it comes to ESG investing

Double-bottom-line returns are not a fallacy

When Cliff Asness talks, people tend to listen.

It’s no surprise then that when Asness decided to opine on the growing trend of ESG investing, many in the responsible investment community took notice.

In a recent blog post titled, Virtue is its Own Reward: Or, One Man’s Ceiling is Another Man’s Floor, Asness laid out his argument for why ESG investing can sometimes dampen investor returns. In the simplest terms, Asness believes that if investors decide to pursue negative screening—or its close cousin, positive screening—as part of a responsible investing strategy, then they have no choice but to sacrifice potential returns. In his words, “pursuing virtue should hurt expected returns.”

On the surface, this argument makes sense. After all, if ESG investing consistently out-performed non-ESG investing then all investors would want to do it. Investors are in the business of making money—of course they would want the highest returns possible (within acceptable risk parameters). But what about the virtuous investor? What about the investor who wants to make a positive impact on the world by withholding capital from “sin stocks” or allocating more to “virtue stocks”?

Asness contends that the lower expected returns are precisely how ESG investors are making an impact. His post breaks down in economic terms how everything in the market has to be owned by someone, and the only way to entice more investors to hold “sin stocks” is via a lower share price. As a result, these companies will face a higher cost of capital, meaning they will need to borrow or spend more than they would have otherwise to fund various projects, expansions or research efforts. Companies that want to lower their cost of capital would therefore have to change their business practices and do less “bad stuff.”

While he makes an interesting—and likely accurate—argument, Asness presents a narrow view that may mislead readers into thinking that all ESG investing is at a negative cost to investors.

It’s not. In fact, research shows that by actively engaging with companies on ESG issues as opposed to divesting from companies, investors can achieve both a significant social impact and outsized returns. Investors can indeed have their cake and eat it too.

The key to this strategy is to focus engagement on ESG issues that are material to the industry and to the company. A recent Harvard Business School study found that successful engagements generated abnormal returns (the different between actual and expected returns) of 7.1% for investors in the 18 months following the engagement.Interestingly, Asness highlighted this exact study in one of his footnotes, clarifying that “it is always possible that more active engagement can change the equilibrium for the better.”

Public engagement on ESG issues has been on the rise in recent years, with the number of ESG shareholder proposals doubling between 1999 and 2013. According to EY, four of the most common shareholder proposals during the 2016 proxy season were focused on human rights, sustainability, greenhouse gas emissions and board diversity. Unfortunately, the vast majority of these proposals don’t reach the critical support threshold of 30%, and are therefore never brought to a vote.

Engagement can come in many shapes and forms. Not surprisingly, the most passive forms of engagement—negative or positive screening—are the least likely to generate the desired results. In contrast, the more active forms of engagement, which can include everything from meeting with company executives to publicly campaigning for a specific shareholder resolution, tend to be more impactful. Research has shown that the more time and energy investors dedicate to their engagement strategies, the more likely they are to drive the change—and the financial performance—that they want.

One firm that has a long track record of public and private engagements on ESG issues is Calvert Investments. Over the course of 2014, Calvert had 379 incidents of engagement with 136 different companies and filed 56 public shareholder resolutions, meaning 83% of the firm’s engagement with companies was done privately.

This focus on private engagement is not by accident—Calvert and other institutional investors know that there is no free lunch in asset management anymore. Investors that want both social and investment returns need to put in the effort to improve their chances of success.

Asness’ analysis tells the 20th century version of ESG investing. The 21st century is a different story. Through active engagement, ESG investors are increasingly finding that double-bottom-line returns are not a fallacy—they are a very real and repeatable investment philosophy. To realize those returns, however, investors need to engage—not disengage—with the companies they seek to change.

Chris Pinney is President & CEO of the High Meadows Institute.