Should You Invest in ESG?

 It's time to explore the world of ESG Investing. In this week's episode, Josh and Austin discuss the pros and cons of investing with a focus on ESG criteria, providing valuable insights to help listeners make informed decisions about their investments. From aligning your values with your portfolio to navigating potential risks, this episode offers a comprehensive overview of ESG investing and its impact on your financial future.

For the full transcript, links, and show notes, visit theinvesteddads.com/196

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Transcript

Welcome to The Invested Dads Podcast, simplifying financial topics so that you can take action and make your financial situation better. Helping you to understand the current world of financial planning and investments, here are your hosts, Josh Robb and Austin Wilson.

Austin Wilson:

All right. Hey, hey. Welcome back to The Invested Dads Podcast, a podcast where we take you on a journey to better your financial future. I'm Austin Wilson, Co-Portfolio Manager at Hixon Zuercher Capital Management.

Josh Robb:

And I'm Josh Robb, Director of Wealth Management at Hixon Zuercher Capital Management. Austin, how can people help us grow our podcast?

Austin Wilson:

We would love it if you'd subscribe if you're not subscribed already, and leave us a review on Apple Podcasts or Spotify or wherever you're listening so that other people can find us, and then they can listen to our episodes and subscribe. It's just a circle of life, man. Circle of life. That's how you can help us. But today, are you ready, Josh?

Josh Robb:

I'm ready.

[0:51] - What is ESG Investing?

Austin Wilson:

We are going to be discussing the growing and somewhat controversial topic of ESG investing. Now, before you ask, ESG, three popular letters, it's another financial acronym. What does it stand for? Environmental, social and governance, and this is kind of correlated to the thinking of socially responsible investing or SRI. People use those interchangeably.

Josh Robb:

It's a side note. We have a lot of acronyms in our industry.

Austin Wilson:

Two or three, yep.

Josh Robb:

And you know who else has a lot of acronyms is the healthcare industry.

Austin Wilson:

Absolutely.

Josh Robb:

Yep. You can get an EKG and all those fun things.

Austin Wilson:

MRI.

Josh Robb:

Yep. And so true story, there was a friend of ours who was a nurse and was going through a lot of... You know you have to keep continuing education in there as well as you do here and always learning, always studying a lot. They work 12 hour shifts, 24 hour shifts. They're always working, and she was exhausted and she was telling me the story that she went into the cafeteria and was looking at the menu and saw one of the menu options was EGG. And she's like, "What does that stand for?" And she could not figure out what-

Austin Wilson:

It was just an egg.

Josh Robb:

It was just an egg, but she could not figure out what that was. And she said she stood there for about five minutes trying to think what that acronym was for.

Austin Wilson:

Her brain was fried.

Josh Robb:

It was literally fried. I like it, or scrambled. One of those two.

Austin Wilson:

It was scrambled. Yeah, one of the two. So let's break down those three magical letters for this sort of thinking. E in the ESG acronym stands for environmental considerations. So really, what that is focused on is the environmental aspects of a company. Does a company have a positive or negative impact on the environment? How they're getting their raw materials, their carbon dioxide emissions, all of this stuff, and if they're using things like renewable energy or recycling products. It could be just thinking about sustainability in general and how sustainable their business model is over time. So that's really the E there.

The S, turn the page to the next letter in the acronym here, social. So this is social considerations.

Josh Robb:

How many friends do you have in your company?

Austin Wilson:

Well, not you, Josh. That's not that many. But there could be a number of different ways to look at this. Looking at diversity, there are a lot of different metrics and ways you can measure that. Labor practices in general, are you paying your people and compensating them well? Do you have a lot of labor disputes? Do you have good benefits and these sort of things, as well as things like, hey, are you hiring indirectly like slave labor in a Third World country? That would look bad on the S category here for you. As well as things like community engagement. Are you engaged with the community? Are you trying to better the community that your factories or headquarters are in by being involved in the planning and the processes around all of that?So that is also known as an indirect discussion around impact investing in general. So this is a way that investors can support socially responsible causes through their investments.

Third letter is G, governance considerations, and this is a big one, but it's very important for ESG investing to look at how corporations are governed. Are they governed in a responsible way? And there's a number of ways to do this, but they would like to look at things like how is the board of directors comprised? Is the board of directors diverse? Are they involved in a number of different industries? Are they all from one background? Just a number of different ways to look at that, as well as-

Josh Robb:

Is the CEO also the board chair?

Austin Wilson:

That's the question. That's one I was getting at next. One of the biggest ones is is the CEO the chairman of the board? And if it is, that's generally not a check mark in the box. They don't like to see that. They like to see some separation there so that the board can keep the CEO accountable. Not often the case actually. In a lot of ways, the CEO is the chairman of the board. The CEO is usually on the board, and in most instances, even nowadays, the CEO is the chairman of the board. So that is one way that people are using their money, and that's one more thing we're going to be talking about, to drive some corporate responsibility through ESG investing.

So 10 pros of ESG investing, then we're going to take a little break because Josh-

Josh Robb:

That's a lot.

Austin Wilson:

You're going to have a dad joke and we're going to do 10 cons.

Josh Robb:

Oh, man.

[4:57] - 10 Pros to ESG Investing

Austin Wilson:

That's a lot. Really, the theme of ESG investing has gained a lot of traction recently because there's been a lot of discussion around sustainability, around climate change, around ethical considerations in business practices and all of this. So let's focus on a couple of different good things that the ESG investing movement has going for it right now, or how people perceive it anyway. So number one is ESG investing allows you to invest your dollars along with your values, so this allows an individual to invest in companies or projects that really align with their personal values, their belief systems, and support causes and industries that they believe in. Maybe that's environmental conservation, maybe that's social justice, but you can put your dollars where your convictions are. So that's a pro. You can align your investments with your thinking.

Number two, risk. Oftentimes with ESG investing, you are able to be investing in companies that are perceived as less risky if they're scored more favorably from an ESG perspective, because these companies often have better risk management which hopefully, not always, but hopefully can lead to more stable or resilient performance during tough times. In the economy-

Josh Robb:

Yeah, the G especially, the governance section.

Austin Wilson:

Yeah, absolutely. So hopefully, that risk mitigation focus can be another layer of maybe some stability for those companies.

Number three, stakeholder engagement. Now, stakeholder is a broader term than shareholder. So a corporation's number one duty is what, Josh?

Josh Robb:

To provide value to the shareholders.

Austin Wilson:

Shareholders. But ESG takes it a step further and talks about the stakeholders, and the stakeholders could be more than just the shareholders, but the employees and the communities that they're in, and really society as a whole would be stakeholders. So are these companies bettering the people that work for them as well as the shareholders and the communities and all of this? So that's the whole stakeholder thinking. But ESG investing encourages companies to engage with those stakeholders and really foster some positive relationships, which hopefully will make the brand be perceived as more strong over time and increase customer loyalty, which is obviously very good for business.

Number four. Companies that focus on ESG often are more innovative and efficient, or perceived to be that way, but they can be looking for cost saving opportunities to reduce resource consumption. This would be the E, the environmental side of things.

Josh Robb:

Can we be more efficient in what we do?

Austin Wilson:

Which can lower emissions because they're capped on carbon emissions, so that also lowers costs, and that can also ultimately improve their supply chain resilience, which as we found in 2020, 2021, it was very important if you have a more resilient supply chain.

Number five, Josh's favorite one, ESG investing and considerations in that category can often align with or anticipate regulatory changes so that you're compliant with, A, the rules that are in place now, or B, the ones that are to come. So compliance, Josh loves compliance, but companies that are proactively addressing those ESG issues are often perceived as better to comply with even future regulations, maybe avoiding fines or legal risks over time as well.

Number six. Many ESG industries are focused on growth markets. So growth markets are things like growing industries, one of those being renewable energy, sustainable technology, and these can actually generate some high growth over time, which is a good thing to be exposed to some growing opportunities.

Number seven. Diversification has become a lot better in the ESG industry.

Josh Robb:

You were limited there for a while.

Austin Wilson:

There for a while, it was really limited, but now it seems like you almost have every category represented with some sort of ESG option, or almost every company is publishing certain ESG documentation.

Josh Robb:

And I think that's the key, is you can find the information a lot easier now than you could 10 years ago.

Austin Wilson:

Absolutely.

Josh Robb:

So then as a result, it's easier for people who are wanting to invest in this to find a more broad group that fit that criteria, or at least to the level they want to see that criteria at.

Austin Wilson:

Yeah. So this is going to allow investors to hold a more diverse portfolio probably than they ever have because they now have access to the information of more sectors or more companies than they ever had before.

Number eight. ESG investing can theoretically drive some positive social and environmental change because that would then push investor capital toward companies that they believe are making a difference. So if you're putting your dollars into companies that adhere to what you believe in, then they'll be able to have more access to easy capital, cheap capital to grow and do more things and continue to grow in that same way, so that could hopefully have an impact on a better world there.

Number nine, transparency and accountability. So companies that are involved with ESG and focused on that a lot tend to be more transparent and accountable to their shareholders and stakeholders, which really ultimately enhances their confidence. And this is through their filings that they're putting out, the detail that they're putting out on all of these different categories, whether that be ES or G. All those different measures that they could do, that's really going to allow people to trust what the company's doing more ultimately over time.

And 10th and Final pro for ESG market demand. It's really become something that's just been more and more demanded by investors over the last handful of years specifically, so as more investors are seeking ESG friendly options, the market has offered more products essentially and more opportunities to do so. So a lot of different pros in the space, and really, this is something that's changed a lot even in the last five or so years. Especially since COVID, I feel like it's really kind of taken off, although the last year or so, I feel like there's been a little bit less of a buzzword out there, but before that, it was certainly a little hotter.

[10:47] - Dad Joke of the Week

Josh Robb:

All right, we're going to take a break before we get to the cons side of things, and I've got a dad joke for you, more of a statement.

Austin Wilson:

I like it.

Josh Robb:

All right. My wife left me because I'm too insecure. No wait, she's back. She was just getting coffee.

Austin Wilson:

That's funny. That's funny.

Josh Robb:

Along with that, my doctor told me I'm too paranoid. Well, he didn't actually say that but I think that's what he was thinking.

Austin Wilson:

Classic.

Josh Robb:

I like it.

[11:18] - 10 Downsides of ESG Investing

Austin Wilson:

He likes it and I like it. That's your dad jokes of the week. So let's turn the page. We've looked at the pros. Now, we're going to look at the downsides potentially for ESG investing, and I have 10 and 10. I did this for Josh. He likes round numbers.

Josh Robb:

Nice and even, thank you.

Austin Wilson:

10 good things, 10 bad things. We're going to try and balance things out so that you can make an informed decision here.

So obviously, it's gained a lot of popularity, the ESG theme over time, but it is really important to note that there are quite a few potential drawbacks for the space as well, so here are a couple cons.

Number one. One of the major criticisms of ESG and investing in general is that it might actually result in lower returns than higher returns compared to traditional investing, so some are really arguing even that excluding certain industries or companies due to ethical concerns can limit your investment opportunity list which can lead to underperformance, especially when those ones that you're not invested in really takeoff.

Josh Robb:

The energy sector had a big run.

Austin Wilson:

If you were naked, like meeting zero exposure or underexposed to energy, the only sector that was up, you probably did pretty poor in.

Josh Robb:

Yes.

Austin Wilson:

So yeah, that's a great example there.

Number two, and this is my shtick I guess you could say, is that ESG criteria is subjective.

Josh Robb:

Right.

Austin Wilson:

There is not a set rule.

Josh Robb:

All three of those are very broad and open to interpretation.

Austin Wilson:

Even how Josh and I ourselves talk about the E, the S and the G, we may have different preferences of what to look for. Put this across the entire investing community, no one can agree on what a good E, S or G is. So it's completely subjective, it varies among different ESG rating agencies, it certainly varies among different fund managers, and that lack of standardization really makes it challenging for investors to compare ESG funds and really assess if they're making any impact at all in those areas.

Number three, this is a popular term for people who are not necessarily the proponent of ESG investing and that's called greenwashing, where they're either making it sound like they're more environmentally or socially responsible than they actually are, or they are just misrepresenting it or exaggerating it in some way, and this can mislead investors who are relying solely on ESG ratings and disclosures. Maybe you put all the right buzzwords so that it fills the Google algorithm nicely, but you're not actually trying to make a difference. That is one example of that.

Number four. While I did note that the opportunity list of investments has grown a lot recently, it also is still rather limited. You have limited diversification because certain ESG funds or investment opportunities might still be more concentrated in certain sectors or industries which ultimately can lead you to less diversification, and this can increase your risk of poor performance if those sectors underperform, and that's a big risk.

Number five. ESG funds or ESG focused financial products can often have higher fees and expenses compared to traditional funds, and those eat into your returns. So if the underlying holdings don't do as well potentially and you're coupling a higher expense ratio on top of it, you can kind of double down on maybe underperformance over time if that just goes the wrong way for that sector or whatever, so that's unfortunate there.

Number six, performance volatility. So volatility can be more enhanced in an ESG focused investment because public sentiment is huge. If a company's ESG perceived value increases a lot, the stock price might go up because that sector of the investor pool might want it and bid the price up. But if it turns, boom, you can-

Josh Robb:

You're in trouble.

Austin Wilson:

Other way, even if the fundamental situation of the company is not impacted at all, so that is huge and must be known as a risk anyway.

And then we've got number seven, potential market timing risks, because when ESG is very in favor and it's a big point of focus, this can really cause ESG favored companies to have a huge run, and then things can get overvalued and then correct, and that can really have some bad timing of how that flows in an investment cycle for people.

Number eight. This whole thinking of ESG investing can really be perceived by a lot of people to have limited impact or lack of impact at all, because you're saying you're causing change by investing your dollars in companies that are doing this, but you're not actually causing the change. You're just investing your money so it's passive ownership of shares, right? You definitely don't have a controlling interest in any of these companies likely, so you're not actually going to be driving any change. It's more for your feeling.

Number nine, this is often looked down upon as well. ESG investing usually uses an exclusionary approach, so they're what we call negative screening certain things-

Josh Robb:

They're looking to eliminate people, not add.

Austin Wilson:

So if you're looking at the S&P 500 as your starting point, you've got 505 companies. Yeah, that's right. 505, not 500. And you negatively screen out the companies that are involved in energy and tobacco and coal mining and yada, yada, yada. Okay, so you're negatively screening out those companies, which is not always the most effective way to drive change. In fact, engaging with those companies to improve their ESG practices could ultimately be more impactful, so exclusionary approaches are sometimes frowned upon.

And number 10. It's not worldwide that there is a lot of access to ESG related products so they might be limited in some regions or asset classes, and this ultimately makes it really hard to make a globally diversified ESG focused portfolio over time. So that is definitely a downside, especially as it relates to we're building diversified portfolios to withstand all kinds of market scenarios. Well, that could be a challenge using this sort of focus.

Josh Robb:

And that kind of plays into as an advisor, I do get asked this question quite often, my thoughts on ESG investing. And pros and cons are very important to weigh through, and for someone that I'm talking with, a client sitting across the table, it's understanding what you could possibly be exposing yourself to, risk, all those things you talk about, are the benefits of investing in a company who's lined up potentially in the same mindset with you when it comes to your impact on the world, are you willing to take that chance? Because remember, it's risk-reward, and this is the same. We're not talking about performance risk necessarily in here. There's a chance of it, but in general, the things that you are opting into, is it worth what you're getting? And it is a risk-reward balance, and so for me, there's not an easy answer. Everybody's different.

How much weight do you put to certain things? I can't answer for a client, but as their advisor, we've got to weigh out the plan. Where are you trying to go? Will this help you get to that spot? Sometimes, it's maybe not focusing so much on this, but in taking your assets and gains and utilizing it for a more direct approach to your values.

[18:25] - Should You Invest in ESG?

Austin Wilson:

And that's exactly where I would recommend, and we're going to get to our opinions but I might as well give you mine now.

Josh Robb:

Go for it.

Austin Wilson:

Yeah. I would say, obviously, I will admit, we have ESG tools at our disposal that we utilize. A lot of data is at our fingertips and we generally know are risks and exposures with what we're investing in. However, to the point that that solely drives our decisions, not always the case. There's human overlay and management overlay to that as well, but our recommendation that I would put together a portfolio for would be saying, let's build you the best portfolio that's going to perform well now and over time, best risk adjusted performance to meet your long-term goals so that you have the best return over time. And then if you have that, you have more assets at your disposal to make a direct impact using your own money to give to the charity or the whatever you feel strongly called to.

Josh Robb:

My opinion falls close to that with the caveat that everybody can feel strongly about certain things. I have certain convictions that I'm just not going to budge on, and if your convictions fall within there, I totally understand when you say, "I cannot own or do not want to be investing or contributing to X," whatever that is. So yes, I think in the long run, the goal is first, give us the broadest chance to reach your goals. Give us the most flexibility to build a portfolio that's diversified and can give you the best overall results, but if there's something that you truly are convicted by, if your advisor won't match that, fine advisor that will.

There's times where someone comes to us and what they want, we say, "You know what? That doesn't really fit with us, and that's so important to you, you need to find somebody that can do that."

Austin Wilson:

Absolutely.

Josh Robb:

And that's very important, so that's where I'm at. But in general, most people, especially in the ESG standpoint, they're not so narrowed in on some conviction that they can't find a way of working around it. On the side of it is biblically responsible investing, you talked about socially responsible investing. The idea of even a more narrower approach, taking even a more limited or more negative screen to even filter down to a specific conviction-

Austin Wilson:

And a lot of people, they go in knowing that they may have a lower return and they're okay with that.

Josh Robb:

Yes, which is fine.

Austin Wilson:

Yeah, they still, they're going to get an acceptable return to what they expect, and that's what they do. And I'll say that as it pertains to ESG, there are deal breakers for Tony and myself managing money here. There are certain companies involved in certain industries that it may be the hottest thing in the world, and we are just not willing to do that. So I would say that most managers have that as well, just as their own personal convictions, which are going to trickle their way down in their portfolios.

Josh Robb:

Yep. Overall, ESG, great topic, been in the news lately. Something that I'm sure people have heard about floating around. Thank you, Austin, for filling us in on what it is and some things to think about. If there are still more questions, feel free to reach out to us at hello@theinvesteddads.com. We'd love to have a conversation with you more, or if you have an idea for a podcast, we always love answering those and putting out an episode based off of somebody's question.

Austin Wilson:

Absolutely. Well, until next episode, have a great week.

Josh Robb:

Talk to you later.

Austin Wilson:

Bye.

Thank you for listening to The Invested Dads Podcast. This episode has ended, but your journey towards a better financial future doesn't have to. Head over to theinvesteddads.com to access all the links and resources mentioned in today's show. If you enjoyed this episode and we had a positive impact on your life, leave us a review, click subscribe and don't miss the next episode.

Josh Robb and Austin Wilson work for Hixon Zuercher Capital Management. All opinions expressed by Josh, Austin or any podcast guest are solely their own opinions and do not reflect the opinions of Hixon Zuercher Capital Management. This podcast is for informational purposes only and should not be relied upon for investment decisions. Clients of Hixon Zuercher Capital Management may maintain positions in the securities discussed in this podcast. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principle. There is no assurance that any investment plan or strategy will be successful.