The Uncomfortable Truth About Sustainable Investing

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ESG (or “environmental, social, and governance”) investing has been one of the hottest entrants to the financial scene in the 21st century. It promises something that sounds too good to be true: You can invest in a way that aligns with your moral compass, and you don’t have to sacrifice returns to do it. But…can you?

We’re joined by Alex Edmans, a professor of finance at London Business School and expert in the field, to help us cut through the greenwashing.

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Our show is a production of Morning Brew and is produced by Henah Velez and Katie Gatti Tassin, with our audio engineering and sound design from Nick Torres. Devin Emery is President of Morning Brew content and additional fact checking comes from Scott Wilson.

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Mentioned in the Episode

• Wealth manager Manisha Thakor in 2022 conversation with NPR (Life Kit)

• ESG as a risk mitigation strategy (Forbes)

• The thorny truth about socially responsible investing (Vox)

• Is ESG profitable? (WSJ)

• Amazon workforce vs. pay

• Anand Giridharadas’s book Winners Take All

• An inconvenient truth about ESG investing (Harvard Business Review)

• One of the hottest trends in the world of investing is a sham (NYT)

• ESG ratings from a corporate governance paper

• Tariq Fancy’s four-part Medium series

• “100 best ESG companies” and findings about Regeneron

• An introduction to the S&P 500 ESG exclusions (State Street)

• Clara Miller, founder and former CEO of the Nonprofit Finance Fund

• HAPI corporate culture ETF from Harbor Capital

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Katie:

Two things can be true at the same time: Your access to resources impacts the quality of life that you’re able to lead. And if you live in the US or a similar country with a climbing cost of living and paper thin social safety net, you know that saving for your own retirement or a down payment or the hospital bill when you give birth is a mostly non-optional fact of life.

And you might recognize that our status quo feels unsustainable, that our growth at all costs mentality carries with it quite a few costs.

We’re currently in the planning phase of an episode that’s going to deal more explicitly with this cognitive dissonance. That is the realization that you personally need to accumulate wealth while realizing that our current path for doing so often means funding the projects of certain technocrats who are building bunkers with a lot of that money. But in the meantime, today we are exploring a free market solution that appears on its face to be the best of both worlds.

Manisha Thakor clip:

“The broad idea behind this style of investing is a belief that you can generate meaningful, measurable societal outcomes while also generating a healthy profit…”

Katie:

That was wealth manager Manisha Thakor in a 2022 conversation with NPR about ethical investing or ESG. The E, S, and G stand for environmental, social and governance respectively. And the idea is relatively simple. Investors who feel a little funny about investing in weapons manufacturers and tobacco and factory farms can seek out funds that have the ESG stamp of approval and sleep a little more peacefully at night knowing their money isn’t fueling companies that do things like seek profits from prisoners or treat animals inhumanely. And good news, somehow, some way, you don’t even have to sacrifice returns in order to do so. The only catch they promise is a slightly larger fee for the fund manager’s troubles. Sounds basically like a win win win, right? Unfortunately, the true story is more complicated than that.

And to my utter surprise and delight when I set out to write an episode about what seems like a fairly boring “eat your vegetables” topic, there’s a lot of drama in this space. So buckle up.

Welcome back to The Money with Katie Show, Rich Investors. Today, we’re unpacking the world of ethical investing to understand just how realistic its value proposition is in practice. My guest today is Alex Edmans, a professor of finance at London Business School and expert in this field. And it was important to me that our guest today was neither a staunch critic nor a cheerleader for this field trafficking and fear mongering or feel good confirmation bias. And as it turns out, Alex has a book coming out imminently about confirmation bias. So I think we are speaking with the perfect person for the job.

So what even is ESG? The interesting thing about ESG and I would say it’s cousin, SRI or socially responsible investing, is that it kind of feels like nobody can agree about what it actually means. The term first entered the mainstream in 2004 in a paper directed at the financial services industry. And in the intervening 20 years, it still feels like we’re trying to figure out what it is. It’s important to ground ourselves in how something like this might work.

In theory, let’s pretend we have a little community with 10 businesses in it. We have the butcher, the baker, the barber, your standard fare. Maybe the barber pays exploitative wages. We might say we’d rather not invest our money in that barber’s business. Maybe he’s really profitable because he is barely paying his employees. But we know that as members of this community investing in a business that’s exploiting the community, is investing in a business that’s exploiting us. Ultimately, we don’t want to profit off of that exploitation because we know we’re hurting our community if we do so. Instead, we might invest in the other businesses and seek returns there. And then now this barber might have less capital. He’s now easier to compete with a new barber who does not exploit his workforce, can enter the market and compete with him. And now we have a choice of who we want to invest in.

Maybe we know that the butcher traces animals inhumanely in order to maximize profits. So we don’t want to invest in his business either. And if an entire community decided not to support that butcher’s business, both by not investing their capital in it and by not patronizing it, the butcher with his sketchy back-alley chickens would cease to exist.

And intuitively, I think this feels really sensible. At its highest level, though, there seems to be one fundamental criticism of how this process is supposed to work. The theoretical problem in public markets at scale is what I’m going to call the paradox of divestment. So that is to say you are selling the shares you own in Apple stock because you know that they are exploiting their laborers in China. So do you remember the story about the nets? Yeah. Okay. So you hear that. You go, ooh, I don’t want to support that company. I am going to offload my Apple shares. In order for you to sell them, someone else has to buy them.

That is to say, Apple is just going to get capital from a different investor now. So you may not own Apple stock, but that didn’t materially impact Apple at all. In other words, your returns are now going to be lower because you don’t own Apple, but you haven’t actually positively impacted the situation. So a little game theory at play here, right?

Then there’s the question of what you’re buying in its place. And this is I think partially where the difference between ESG and SRI that socially responsible investing comes in. Does the fund merely reduce harm, which is good, or does it also put something generative in its place? Does it take that money and invest it in something that’s better? A Forbes article says, “An ESG portfolio that reduces its exposure to ExxonMobil is less bad. A portfolio that eliminates the company entirely might be better, but a portfolio that adds First Solar in ExxonMobil’s place is positive and sustainable.” So they kind of go on to say that ESG at its core is a “risk mitigation strategy,” while SRI tends to seek out companies with business practices that affirm a certain moral stance.

Right after this quick break, we’ll get right back into it.

There’s how it would work in theory, which is the broader high-minded promise of investing in these types of funds. Then there’s how it works in real life dictated by more than a reported 600 ratings agencies per Deloitte that offer the stamp of ESG approval. As a result, you get the sense that ESGs critics outnumber its supporters, but their reasons for critique very widely.

It’s a little like the horseshoe theory of politics that the far left and the far right might agree that this idea is bogus, but for radically different reasons depending on who you ask. Ethical investing is either a trick played on us by wealthy bank executives who think they can fool socially conscious Gen Zs and forking over more of their meager paychecks by greenwashing their funds. It’s a distraction from the urgent matter at hand that only really serious government intervention can fix, or it’s a liberal do-gooder return squasher that sacrifices the almighty supremacy of shareholders at the altar of virtue signaling and something carbon credits.

As Andy Bahar, CEO of As You Sow, a nonprofit that promotes environmental and social corporate responsibility, told Emily Stewart at Vox, “You may hold companies that are profiting from burning down the rainforests, profiting from private prisons, profiting from climate destruction, and you have no idea. It’s very, very difficult to figure it out.”

I too found it difficult to triangulate any meaningful truths about this topic because a lot of the coverage seemed to be discussing entirely different things. For example, my operating assumption going into this episode was that we were going to be talking about avoiding investment in companies that I don’t know, pollute rivers with toxic chemicals or exploit minimum wage workers. And at the very least, I expected to encounter a compelling argument for investing in solar panel companies.

Instead, a lot of what I found focused on what companies are saying, not what they were doing. Take this example from the Wall Street Journal: “Corporations that remain neutral on social and political issues outperform companies that lean left.” The Wall Street Journal piece found that 25% of S&P 500 companies took no political stance, more than half scored as liberal, and less than 15 scored as conservative. And so the papers conclusion when comparing returns was that, ooh, the liberal ESG companies are underperforming the index as a whole.

But I don’t know, when I think of a company that falls into a sustainable investing or ESG landscape, I don’t think about a company that posts a “Happy Earth Day! Save the planet!” TikTok and then turns around and dumps tons of toxic waste into the ocean. It’s not, or rather, I wouldn’t think it should be about their public facing stances on lightning rod political issues, but about their actual business practices. You might not want to invest in weapons manufacturers. You probably don’t care whether those weapons manufacturers are posting an Instagram for Women’s History Month.

And as for their results, I’m not exactly shocked that the most profitable companies in their index are those with the worst labor practices. I mean, for a particularly famous example, Amazon’s workforce is 1.5m people and their average revenue per employee, meaning the average revenue generated per person is $333,550 as of 2023 according to Yahoo Finance. But the average annual pay for an Amazon employee from the warehouse workers all the way up to the executives is around $74,619 per year with roughly 63% of employees earning less than $74K according to ZipRecruiter.

So the authors of the Wall Street Journal piece write, “The dat, indicate that as common sense would suggest companies that focus on profits outperform companies that don’t.” And they are of course arguing this in reference to the idea that asset managers have a fiduciary responsibility to clients to seek the highest returns possible. So that dictates where a lot of the big institutional money is going to flow.

And I tell you all of this to say there is a lot of noise in the space, which can make it hard to take an ESG label at face value doesn’t mean this company is a net positive for society or that they have aligned themselves politically with progressive ideas while completely ignoring them in practice.

And some thinkers would warn us that looking to free market solutions for these broader problems is a fool’s errand. The doing well by doing good charge has been adroitly criticized by Anand Giridharadas’s book “Winners Take All;” his argument is that profit seeking band-aids for real societal ills do just a good enough job of allaying the pain that they prevent real change from taking place.

Okay, so now we need to talk about how this is working in practice and the current state of things. So at this point you might be feeling like we’ve taken a big fat dump all over the world of ESG investing. You might be sitting in your car or you’re walking around your neighborhood thinking, yeah, Katie, okay, but isn’t it a good thing that we’re at least trying to invest in a way that doesn’t make the world worse?

And to that I say, yes, it is a good thing, it’s a good thing that we care. It’s a good thing that we’re trying and talking about it. But as the Harvard Business Review calls it, it’s a bit of a quote, “inconvenient truth” that the current iteration is that some research shows companies in the ESG portfolios actually had worse compliance records for both labor and environmental rules. And the writer theorizes that it’s a twofold issue: The first is that companies are using this as a front for poor performance, kind of like a marketing spin to mask poor performance. And two, that the principles themselves are not all that meaningful. That is to say the designation as it exists today is about as slippery as you may have already concluded.

So to get into that a little bit more, according to the New York Times reporting, the criteria for an ESG label is wide ranging. It includes carbon emissions, pollution, data security, employment practices, you name it. And it’s determined by ratings agencies that allegedly measure ESG viability by how much potential harm their ESG factors have on a company’s bottom line rather than how much harm their business is causing. So in other words, according to a corporate governance paper from Harvard, many rating systems measure how much potential harm a business is exposing themselves to due to ESG factors. As in, Hey, we know this company is like dumping toxic chemicals in a river. What’s the long-term financial risk of that? And so the New York Times concludes that this system is very lenient.

Tarik Fancy, an ex-BlackRock CIO for sustainable investing, described how “negative externalities are a more appropriate measure in our economy. Pollution is an example of a negative externality. It is an undesirable side effect from an industrial process for private profit that we have broader public did not choose to incur, but for which we collectively bear the consequences.”

So if you’re like, what does all this mean in practice, a reported 90% of stocks in the S&P 500 can be found in ESG funds like Alphabet, Meta, BP, and Exxon. So out of curiosity, I googled ESG stocks and randomly selected one from a list that purportedly included the 100 best ESG companies. It was called Regeneron Pharmaceuticals. So I thought, huh, I’m going to look that up. Let’s see what Regeneron is all about. Only to see a memo from the US DOJ from three weeks ago about how Regeneron is under fire for fraudulent drug price reporting alleging that they inflated Medicare reimbursement rates to extract more money from the Medicare system. And at that point I was like, well damn, what is an ESG if all this shit is ESG, what’s not?

And so I looked it up and found a State Street paper from 2020 that details the exclusionary criteria for the 23 stocks in the S&P 500 that are not ESG. And we get businesses like Johnson and Johnson and Wells Fargo because they don’t comply with what’s called the UN Global Compact principles on human rights labor environment and anti-corruption, though it does not elaborate on how they don’t comply, and you get companies like Boeing, Lockheed Martin and Raytheon because they make controversial weapons. Depending on which ratings agency and investment firm is relying on for their guidance, you’re probably going to get different results.

That’s kind of the main takeaway here. And so let’s go back to Tariq Fancy for a moment because he really shook up the ESG world a few years ago when he left BlackRock and went on to publish this quite damning four-part medium essay series called “The Secret Diary of a Sustainable Investor” that tried to basically out the entire field as a sham. So this is what I was referring to earlier when I said there’s a lot of drama.

If you’re really big into the sustainable investing world, this man probably needs no introduction, you know who he is, but his beliefs are compelling, I think, if flawed. And our guest today is going to contend that there are some serious flaws. But he does not mince words. He calls sustainable investing “a dangerous placebo that harms the public interest,” a mirage in the middle of the desert causing us to waste valuable time as the climate clock ticks down. And I spent a couple hours reading all the essays, his writing style is actually really enjoyable. We’ll link them in the show notes for you. And in part two, he quickly notes the mismatch in short-term versus long-term goals, how fund performance is assessed quarterly or annually, while the long-term impacts of sustainable choices take many, many years, if not decades, to bear out, which makes financial markets a suboptimal place to address these existential challenges that humanity faces.

And you get the sense that his Gulfstream PJ shuttling between important conferences with elites all over the world, left the impression with him that, hey, maybe these are not the people who are most legitimately incentivized to change the status quo. These are the winners of the status quo. And he writes, quote, “At such a critical time, should such important decisions for democratic societies be left to occur in a private forum like this with decision makers whose financial interests may not line up with the long-term public interest?”

Plus he says, a CEO of a publicly traded company can’t do something that can’t be justified by shareholder interests. That is to say, anything they do that’s good for the world must also be positive or neutral for shareholders. And so the arguments be made is that ESG is supposedly good for marketing and therefore good for business.

And here’s where things felt a little at odds with the earlier argument that I set up for you. If you recall the Wall Street Journal article we discussed basically claims that ESG companies underperform or at the very least ESG companies as defined by holding politically correct beliefs. So I don’t know how both of these things can be true. How can it be good for marketing and something that you should be doing and also a sign that you’re going to underperform? I don’t know.

But regardless, Tariq’s thoughts on the so-called free market echo that of previous money with Katie’s show guest Nick Hanauer. Tariq says, “Fixing the rules of this system so that it produces better societal outcomes is not intervening in the free market, especially as there is no such thing as a free market in the first place. A market economy is at its core a collection of rules, no rules, no market. Just as every competitive sport has clear rules, competitive markets need rules, no rules, no game, nor is there one set of pre-ordained rules. Every rule ranging from the number of years a new idea gets patent protection to the corporate tax rate is a deliberate decision that has implications for outcomes of the system. And if we change the rules of the game will get different outcomes, all of which can be described as market outcomes. Changing those rules is no more an intervention in the free market than it was for the government to create that rule in the first place, or for the NBA to decide to draw a line on the court behind which successful shots are worth three points.”

Tariq’s viewpoint basically takes the concerns that I just presented to you, that these ratings agencies aren’t really judging companies in a way that can create effective change and market dynamics mean capital shifting around doesn’t actually change anything, and takes it a step further.

He believes that not only are these measures ineffective, but that they’re a feel good distraction from the type of painful change that is necessary changing the rules of the game for everyone. And in case it’s not obvious yet, the majority of his work focuses on climate change as the biggest threat. And this is I think really broadly what ESG funds were supposedly targeting. He said, “If you really care about social changes, invest your portfolio as you’ve always done, which is to get the best returns and preserve your savings and then turn to the government and push political action around solving climate change because that is the only level where it can actually be solved.”

It feels like it all begs this question, do you want to feel better about what you’re investing in or do you want to do something that’s actually going to change things for the better? And my guest today is going to tell you why he critiques the idea that that is an either/or.

Unsurprisingly, not everyone agrees with Teresa’s assessment. Clara Miller, for example, is the founder and CEO of the NGO Nonprofit Finance Fund, and she said that he may be the last one to have discovered that the rules need to change. Sidebar, her interviews are so sassy and fabulous, we really wanted her to come on and talk to us, but she was traveling, but she believes that his cynicism underestimates the power he and others like him wield and like what he could have done as a BlackRock executive to help including what she would tell those very same people to do now, which is stop lobbying against climate legislation and lobby for it instead, start lobbying for carbon taxes, require more robust disclosure metrics, and she named a few key governing bodies, pay your taxes and pay your workers enough money to avoid public assistance.

Another person who disagrees with Tariq’s conclusion is our guest today, Alex Edmans. He claims that Tariq effectively tears down a strawman argument and points specifically to the center of the Venn diagram where companies making better choices can actually benefit shareholders. His research, which we’ll talk to him about today, show that companies that treat their employees better outperformed by roughly 2% to 4% per year.

And I mean it makes sense if you have one firm where people are happy, they feel supported, they’re being mentored, they’re more likely to stick around, they’re probably going to do better work, they’re probably going to cost the company less money to replace them. Obviously, as a proponent of fair labor standards as well as a rabbit seeker of returns, I was very interested in this finding. So I went looking for an ETF that tried to track employee happiness. I was like, well, if we know that that is a better mode of operating, how can I invest in that?

And I found the HAPI corporate culture ETF (ticker: HAPI) by Harbor Capital that tracks companies with the happiest employees. And I quickly cross-referenced its year to date performance against the S&P 500. Sure enough, it is outperforming by roughly 2% right now it has an expense ratio of 35 basis points or 0.35%. So it’s definitely on the higher side, but you’re still, I mean, if you’re outperforming by 2%, still net positive. That said, it was created in October, 2022. So it’s not exactly a treasure trove of back-test data, but so far so good, right?

Except here’s the hard part. I looked into its holdings and I just want to read you the top 10: NVIDIA, Amazon, Microsoft, Apple, JP Morgan, Chase, Eli Lilly of famed insulin price gouging, Alphabet, class A and class C shares so they’re counting it as two, Meta, and MasterCard.

So again, it feels like, oh wow, this sounds really nice. Right? And then the second you dig deeper, you realize just how subjective these types of qualifiers are. It’s really hard to quantify, codify an ethical code. In fact, it feels nearly impossible. I think about Apple for example, when they’re measuring employee happiness at Apple, are they just asking the corporate employees who are being paid a ton of money and probably are having a great time with free snacks? Are they asking the people that are making the iPhone if they’re happy? Probably not, right? I don’t know how else it would end up on this list. So it still feels like it’s lacking a holistic lens, but we will get back to my conversation with someone who might make all of this feel a little more manageable right after a quick break.

So Alex, welcome to the Money with Katie Show. Thank you for being here today all the way over the airwaves from London. You debated Tariq Fancy for a Wall Street Journal piece back in 2021, and in it you said something that struck me as I just thought it was sweet. It was like, I feel modestly better about ESG than he does. And you said that this was because you’ve seen some of the positive effects of it firsthand, and I believe you mentioned Exxon and particular appointees to Exxon’s board that were focused on climate as an example of a consequence of ESG. So can you share a little more about what you see as the largest benefit and reason to believe in the field of sustainable investing? Are we being overly cynical if we’re claiming that this problem is one that’s too big for ESG to solve?

Alex:

First, Katie, thanks so much for having me on your show. So can I start with the second question first, which is, are we being cynical by claiming that the problem is too big for ESG to solve? Of course. I don’t think we’re being cynical. I think we are being realistic, and actually I do agree with Tariq Fancy that we need government regulation. But where I slightly differ from him is I think the problem is so big that we can’t just achieve it with government regulation. We need both government regulation, company action, investor action, consumer personal action. And so why might investor action be useful? Because many ESG factors in the long-term, they’re not just good for wider society, they’re good for long-term shareholder value.

So let’s go back to the Engine No. 1 situation. How did Engine No. 1, a tiny hedge fund with a tiny stake, manage to get three climate friendly directors appointed to the board? It’s because they highlighted the shareholder value consequences of having a board without that expertise, not just the environmental consequences. And that’s why other investors such as BlackRock came on board and voted for the engine number one nominees. And if you look at BlackRock’s statement, they claimed that the lack of expertise was a corporate governance issue, not an environmental and social issue, but a corporate governance issue that threatened the long-term financial sustainability. So there are many ESG factors in the long-term that also will affect shareholder value.

Katie:

Yeah, that’s interesting. On one hand, I mean I can see this overtly cynical point of view, which is like what we’ve alluded to so far, which is, well, these companies are in business to make money. They’re worried about this quarter, they’re not worried about 50 years from now. But I mean, if you’re really playing the long game with shareholder value and profit, it’s kind of hard to be a profitable business if civilization is gone or if the earth is no longer habitable.

Yeah, I do think it’s funny that all of this, in order to be acceptable to we’ll say fiduciary standards or the idea that in order for a CEO to do something, it has to be in the best interest of the shareholders. That is the lens through which we are looking at that in the business sphere.

Alex:

Even if that is the lens, so let’s say the lens is shareholder value, actually shareholder value is inherently a long-term concept. You learn in Finance 101 that shareholder value is the present value of all future cash flows until the end of time. And that’s not just true in theory, that is true in practice as well. So some of the most valuable companies in the US are tech firms whose valuations cannot be justified by quarterly earnings. They’re justified by their long-term potential. And so even if a company is trying to maximize value for shareholders, shareholders are forward-looking and realize that it’s important to invest for the long-term. And this is why we often see investors forcing companies or pushing companies to go faster and further on issues such as corporate culture, DEI, environmental impact than companies might do themselves.

Katie:

Interesting. A follow-up I would have to, that concept is that, I in theory agree and I think that that makes sense. But then also I see the behavior of certain US firms like a Boeing for example, where there is this long standing history in the 2010s or the early 2000s, post-McDonell Douglas merger where they were spending so much more money on stock buybacks than R&D. And it’s perhaps an oversimplification of the narrative. In fact, I’m almost certain it’s an oversimplification, but I feel like we’re almost seeing the long-term ramifications of those decisions now, and we’re trying to boost earnings per share, and in the process we are investing in the core product of what we build, which is airplanes and the engineering of those airplanes.

So in your view, would that be an example of just like yes, in a case like that the firm was not looking at the long-term? Or how does that square for you with this rational economic model that shareholder value is supposed to be focused on the, because I feel like in practice we often see the opposite.

Alex:

So that’s an example where I’d say the company was not maximizing shareholder value, it was maximizing short-term profits and short-term profits might be different from shareholder value. So why might there be a misalignment? Sometimes incentive schemes for chief executives are poorly designed. They are focused on some short-term targets. What I’ve always been about is tying the CEO’s pay to the long-term value by giving him or her large equity stakes, which they cannot sell for seven to 10 years.

Katie:

Brilliant. Okay. I love it. I was like, gosh, it feels true, but where is the misalignment? So we talked in the episode about the basketball game analogy that Tariq makes, which I found pretty compelling when I read it, how rules and referees are critical that there’s no game if there are no rules, and you point out where you agree. And you also point out a few areas where you feel like these are critical flaws that undermine the analogies potency. One of which is the idea that some of the benefits of ESG investing as you see them pertain to things that actually cannot be regulated, like corporate culture. You can’t fix a culture with policy. So can you elaborate a little bit more on that particular piece of your counter argument?

Alex:

Certainly. So again, I agree with Tariq Fancy that where a regulator can affect things than they should. So regulation should be used if it’s effective, but I disagree that we can just leave everything to the government. Number one, the government does not act perfectly. So both the governments in the UK and the us, they’re not, there are many things that they could be doing better. So it may be that the government is lobbied and that’s why they’re not taking certain actions.

But second, and this is the point that you are asking me about, even if a government was perfectly benevolent trying to do a good job for the citizens of a country, there are certain things that it’s hard to regulate because it can’t be quantified and therefore it’s difficult to prosecute. So let’s go with corporate culture. Yes, you can regulate things like wages and holidays and working conditions and child labor, but what does corporate culture involve?

So I go back to my first job at Morgan Stanley that involves giving meaningful work delegation, taking a junior analyst like me to a meeting. Or if I wasn’t taken to the meeting, my boss would spend a few minutes calling me on the way back saying, “Hey Alex, the meeting went really well. And by the way, the analysis that you spent the weekend doing this came up in the meeting. The client was really impressed by how well we understood the issue.” So there’s many things which are just good management, mentorship, which you cannot regulate. And so this is something that sometimes investors will get involved in trying to improve culture, not just quantifiable things.

Katie:

Beautiful. I’m glad you touched on wages and paid time off, sick leave, parental leave, things like that. I know you’re in the UK and a lot of that already exists there, and we don’t have those things in the US. So sometimes I think about corporate culture and I’m like, well, a lot of that stuff can be regulated, but to your point, the culture of management or competition or the overall vibe within a company is not easily addressed by policy. So I think in a sense, all of this gets to a broader question that we’ve been trying to answer in this episode, which is doing well by doing good a real thing. And as much as I deeply want to believe for my own confirmation bias and to resolve cognitive dissonance, that I feel that running an ethical business leads to better business results. There is another side of me that finds the argument a little bit dubious, given what we know about how public companies create profits.

So the status quo, and back in 2012, you published a paper that studied the link between employee happiness and profits, and you found that companies listed in the a hundred best companies to work for in America generated 2.3% to 3.8% higher stock returns per year than their peers from 1984 through 2011. And then I believe the same analysis was conducted again in 2020, and they found similar results. I think their results were slightly diminished, but usually when opportunities for alpha like this are discovered, I think the rest of the market adapts to capture it too. And so I’m curious, when you think about your own research and you think about the research that aims replicated just four years ago, do you think that the results are diminishing because firms are catching on or are they not diminishing? Do you think that that’s actually within the same window when you say no, actually the market’s not catching up to this?

Alex:

I think that’s a great question, Katie, which has a couple of levels to it. So is doing well by doing good a real thing for companies and it’s a real thing for investors. So let me take these two things separately.

So let’s start with companies. Can companies do well by doing good? Now, some people will say, well, that’s just wishful thinking. That’s just assuming there’s free money that you can just magically create. And I would say there is sometimes free money because if you thought there was no opportunities free for free money, that would be assuming all companies are operating at 100% efficiency, they could not do anything better. And I would say that’s not the case. There’s many companies that are acting below their potential, and I think one of the big ways they’re doing so is they’re not getting the most out of their human capital.

So what I showed in my paper is that companies that treat their workers better, perhaps having some of the culture improvements that I just discussed in my answer to your last question, they do deliver higher profits in the long term. And so what this suggests is that the pie is not fixed. You might think that the pie is the value that a company creates. It can be divided between shareholders in the form of profits and workers and wider society in the form of fair wages and fair prices. It’s not the case that if you are doing well, doing good for workers, you are giving up part of the pie and making shareholders worse off. Instead you are growing the pie. And shareholders can also benefit in the long term.

But the second part, and this is why I really like the question, is if something is good for companies, it’s not necessarily good for investors if it’s a ready priced it. So if everybody were to see my study and recognize that companies, which are great places to work will perform well in the long term, then shouldn’t investors latch onto this by these best companies and therefore there will be no alpha anymore. And you might think, well, that should be particularly the case now that corporate culture gets so much of attention given the importance of ESG. Well, the answer is that it hasn’t been the case, at least not yet. And that’s why the replication in 2020 still found some alpha. So why might this be?

Because often ESG investors look at quantitative factors like pay and benefits and diversity. These aren’t bad things, these are relevant things, but they don’t capture everything which is relevant about a company’s workforce corporate culture, which is more intangible, which might be off the radar screen of many investors that might still not be priced in, and therefore a savvy investor who notices this might be able to trade on this and generate alpha from that.

Katie:

Yeah, it’s interesting that you mentioned that too, because when I was reading some of your other work, I think I saw something where you were even expanding upon the definition diversity to include, are we including people who think differently? Are we including people who have different personality types? These are all things that can make a company more effective that kind of typically get left out of the typical definitions. And so that’s just kind of what that’s bringing up for me. I’m curious if you’re familiar with Harbor Capital’s HAPI ETF, that seems to be capitalizing on your findings. Have you seen this?

Alex:

Yes. And I believe that one of the co-founders of this is Dan Ariely, a great behavioral economist. So we’ve chatted about my work and what the potential of this work is to guide their investment strategy.

Katie:

Gosh. So I did look at year to date performance. I was curious, and I noticed it is outperforming the S&P 500 by 2%. So I was like, oh, wow, I’m kind of surprised that all these puzzle pieces are fitting together so nicely. But then I looked at the holdings and I was surprised to see some of the companies that have been called out for what we’ll call aggressive labor practices in the past. And it got me wondering about whether or not it’s even possible to quantify an ethical code as an investing framework. I mean, I really went down the existential rabbit hole here that, not that we shouldn’t try, but that the feel good emotions might be a bit of an anesthetic to this broader issue if we’re saying, okay, we’re including all the companies where the employees are really happy and Amazon is included. And then you look at the articles that have come out about Amazon and what it’s like to work in a warehouse and you go, well, I mean are they happy? What are we even basing the happiness on? So I’m curious what you think about that and how you think about the idea of codifying ethics or the index you might use to determine what would make its way into an ETF like that.

Alex:

Certainly. So what an ETF typically will look at is a company’s current performance on the relevant investment theme. So if they’re looking at employee satisfaction, it’s how well they’re treating their employees right now. It may well be that some of these companies had some labor controversies in the past, but if they recognize, well, that was really bad, let me try even harder to make sure that we don’t have a situation like that again, that may well be a good investment thesis. And even for some of the companies, which right now might still have some controversy, it’s not clear to what extent this is widespread.

So if Amazon is in this list, I recognize that they still might have some concerns with the warehouse practices, but is this indeed widespread across all of the warehouses? So often you’ll have cases in which this will be reported in the news. My wife actually works for the data science team at Amazon and has to tour the warehouses as part of a job. And certainly the ones that she’s seen, those people do seem to be very satisfied. Now clearly she’s only seen a subset, but suddenly the journalist also looks at a subset looks at one or two, which are most likely to make the news. And in a very large company, it’s unlikely to be the case that every single warehouse is absolutely happy. And also that is one part of the employee base. There’s lots of other employees there. And if it is that generally the employee culture is positive, then that might be ripe for inclusion.

And then this nicely dovetails towards the second part of your question, which is, is it possible to quantify an ethical code? It’s not. And that’s why I think it’s a great thing to invest on.

And that might seem bizarre because if you can’t quantify it, it’s difficult. But if it’s difficult, then that’s where the alpha is. So let’s say there was a universal simple measure of employee satisfaction, everybody would invest on it. And it would priced in just like the diversity comment that you made earlier. If simple demographic diversity were correlated with financial performance, everybody could do this. A robot could put on the trading strategy, whereas what my paper looks at is diversity, equity, inclusion, how psychologically safe your corporate culture is, how much cognitive diversity is there within the workforce, that is more difficult, and that’s where the true alpha might be.

Katie:

Huh. Wow. Okay. I think I just had a little brain blast moment. Thank you for that. I had not connected those dots, so I’m glad that you did.

I think we’ve already talked about this a little bit. We’ve talked about the idea that a bigger pie can be created, which is actually one of the other holes that you poked in the basketball analogy that we’ve referenced, which is that basketball is a zero-sum game. There can only be one winner, but what we are talking about here is not a zero-sum game, and that activism on ESG issues creates shareholder value as a byproduct, and that engagement on shareholder value ends up improving ESG.

So I’m curious that in my mind when I hear this, I think, okay, we’re voting with our dollars in this way. We are investing in things that further the type of world we want to see. And what I think I’m hearing you say is that we’re creating a bigger pie in doing so. I’m curious if you can elaborate more on how that creates shareholder value as a byproduct.

Alex:

Certainly. So let’s start with the S of ESG. So if you are treating your work as well, they’re becoming more motivated, more productive, more likely to stay, and that was something that I showed in my earlier paper.

What about the environmental issues? If you are doing something which uses fewer resources, that’s good for the environment, but it’s also good in terms of shareholder value because it’s less costly. So just to give one example, there is Costa Coffee, a global coffee chain, and it manufactures its crockery in China, and then it ships that crockery from China to London. London is the distribution hub to send around the crockery to all the Costa Coffee outlets throughout the world, including those in China. So they used to be sending it from China to London and back to China. So a shareholder just noticed this, came in and said, well, this is just a big inefficiency. And that shareholder was motivated by long-term shareholder value, not by environmental impact per se, but if you are doing things to make the company more efficient, more productive, you are consuming fewer resources.

And that’s why it can also help create environmental and social value as a byproduct. Now, you might think, well, that’s one simple isolated example, but in my earlier book, Grow the Pie, I look at large scale academic evidence to suggest exactly as you say, often dedicated engagement on environmental and social issues creates long-term shareholder value and engagement on financial issues also creates environmental and social value as long as the engagement has the long-term mindset in mind as we discussed at the start.

Katie:

Interesting. Yeah. I’m curious on that as a follow-up, if there are examples that you would point to and say it works differently, and maybe it is only if that long-term piece is crucial because anytime that we’re seeing this not function this way, it’s because of a short-term mindset. So for example, my dad used to work for a company called Dow Chemical, and we lived in the Ohio River Valley, and there was a town in Ohio where I believe it was found that DuPont, I believe it was DuPont, was dumping chemicals into the water supply because it was a cheaper way to dispose of them. There was a really crazy rate of cancer in this town because the chemicals were getting into the water supply. In that instance, I would go, okay, that company was looking for a way to we’ll say, increase efficiency or make their operation cheaper. And the route that they chose was something that was patently bad for the environment and for the community where they were. But I’m trying to connect the dots here as well.

Using the mental model that we’ve established is the thinking then that yes, and that was bad for shareholder value because the long-term consequences of that are eventually you do something that you’re going to be found out and there are going to be fines and there’s going to be blowback. And that’s not a situation anyone wants to find themselves in. Same callback to the 737 Max had Boeing predicted that was going to be the result of what they were doing, and if they would’ve taken the long-term view, that would not have been the path they would’ve chosen. But does it all hinge on this short-term versus long-term what you’re optimizing for?

Alex:

So that’s a really important determinant. So it’s absolutely not the case that every single type of engagement is good. There can be engagement to try to increase short-term profits by reducing investment and paying out dividends. That’s clearly bad for the long-term.

But I also want to stress that sometimes ESG engagement can be short-term. So we often have the myth that financial is always short termist and ESG is always long termist, but there can be some good financial engagement to increase productivity, which is beneficial in the long term. And conversely, there can be some shareholder engagement, which has short-term motives. And in particular, there’s a nice academic research on gadfly engagement. So those are investors which don’t have a large skin in the game. They don’t take large stakes and do a lot of research, but they make lots of shareholder proposals. And some of this can be micromanagement.

So sometimes what this might suggest is to get the fastest way to achieve a particular ESG target, even if it might not be good for the long term, for example, to achieve a particular diversity target in senior management. One thing you could do is just to hire some minorities from another company. So that would achieve the target quickly, but that might be the expense at organic growth throughout the firm. It might actually purchase ceiling and a bit of value to some juniors who have to otherwise get promoted. It’s also not necessarily good for society as a whole because you’re just hiring some people away from a competitor, so you’re not increasing the number of minorities and senior positions in the industry. So sometimes it may well be that a company is already doing a good job and recognizes the need to develop a diversity of talent. And it can be that an investor who wants a quick win in order to generate some good publicity will try to engage or pass the shareholder proposal, and that can sometimes backfire.

Katie:

Interesting, interesting. Okay. So to recap and to make sure I understand, the concept basically is on the face it looks like a good thing, but really the ultimate goal of developing a more diverse talent base or workforce in an industry is to increase the diversity. And so if you’re just taking someone from a competitor to satisfy and check a box, you actually haven’t furthered the goal at all. You are just using a super short-term mindset.

Alex:

And also this is might be demotivating for the people on the inside who might’ve otherwise got promoted and now they see it’s a top-heavy organization. Or it might suggest that your own internal strategy of developing diverse talent was not succeeding, and that’s why you needed to bring in somebody from the outside. So it can send a negative signal in so many other ways, but if you are an investor and what you want to say to your clients, hey, we are really good at promoting diversity, we increase the diversity of this organization by this amount, then that can be a quick win, even though it’s not actually good for long-term value.

So often in many cases, the company knows much more about human capital than an outside investor, and so they might know best who should be in senior positions within the organization, obviously if top management has sufficient long-term incentives rather than short-term ones.

Katie:

I’m curious at the end of the day, knowing everything that you know and spending so much time thinking about these questions, how do use square your “both and” framework of regulatory change and making individual choices, what would you as an investor choose to invest in? Because I think we have a tendency, I know I have a tendency to point to political action as the only path forward and go, well, that’s what needs to happen. We need regulation. But that also feels like a bit of a cop out because it means conveniently that my behavior doesn’t have to change at all. But I think that you have made a real case here that if A, we’re thinking about this as a scenario wherein actually pointing to a HAPI ETF, actually voting with your dollars in this way is going to get you better returns, and that [B], political action is inclusive individual choices. I am just curious what your investor philosophy is.

Alex:

Again, great question. I’ll answer this on different levels. So number one is climate change or ESG issues are so big that I believe we need all aspects of the system to work together. And why I’m somewhat perturbed by sometimes these debates is people have quite binary thinking. So some say it’s only government action, new investors are completely wasting time because it’s only the government. And then there’ll be some investors who say, Hey, we got it. You don’t need anything. We are going to change the world all by ourselves. And if you have an extreme viewpoint, you might get a lot of airtime because then you can have a lot of people back in your corner if then the government camp or the investor camp.

But in reality, we need action by all of these people. This might be why I as a consumer will try to do things like recycle. I bike a lot. I only just bought my first ever car about a year ago, which is a secondhand electric vehicle.

So we can certainly do things at the individual level, but this doesn’t mean that the investor level is not going to be important as well. So the biggest holding in my portfolio, and I’ve held this since 2007, so this is a 17 year holding, is the Parnassus Endeavor Fund, PARWX. This used to be called the Parnassus Workplace Fund and was actually the first fund set up on this employee satisfaction strategy. So I do believe in the findings of my own research, and so this is why this is one of my biggest holdings. So they’re now called the Endeavor Fund, not the Workplace Fund, because they have a fossil fuel exclusion in addition to the employee satisfaction core thesis.

Katie:

Huh. Okay, cool. I’ll check that one out. I didn’t see that in my research and trying to, well, research is a generous term. I didn’t see it in my Googling when I was trying to find funds that were trying to mimic those findings. But thank you so much for being here. I really appreciate it.

Alex:

Really appreciate the invitation. Thanks for the conversation.

Katie:

So I hope you enjoyed that conversation. I have to say, on a personal note, I think he clarified something for me that I hadn’t connected the dots, right? I really understood viscerally Tariq’s points about how if I am an executive at a company and I’m the one making the decisions, because if it’s the board and it’s the executives who are making these decisions, and I’m incentivized to make short-term decisions because that’s how I’m compensated is in stock that is going to either go up or down this quarter, I’m really not incentivized to prioritize the long-term. I’m not incentivized to maximize shareholder value as a human being. I’m incentivized to maximize the money that I’m taking home this year, right?

I really liked Alex’s point about how changing executive compensation structure, changing the incentives for the people who are making decisions, the top brass at these companies, and saying, well, you’re going to get compensated in stock, but you can’t sell it for 10 years.

So it doesn’t really benefit you as a person to make a decision that’s going to benefit the sale of your shares that you’re planning this year if it’s going to be bad for the company long term, which is where I think the Boeing example is a great one that we’ve made. We’ve talked a lot about toxic dumping in rivers, but I think that aligning those two things and more closely aligning the incentives of the decision makers with long-term outcomes makes a lot of sense. So I really appreciated Alex’s ability to kind of thread that needle for me and his emphasis on the idea that it’s a “both and” — that yes, we need government action, we need new regulations, we need these things to change, but at the individual level, we aren’t powerless. And to assume that we’re powerless is a little bit of a cop out. So I really enjoyed that part of the conversation. I hope you did too.

I also appreciated that he name dropped another fund that he’s been holding for a long time, the Parnassus Endeavor Fund. So perhaps worth checking out that one as you check out the HAPI ETF, and at least now you’re aware that those things are out there, whether or not the underlying holdings are the best things possible remains to be seen. But maybe you can do your own direct indexing of some kind.

And that is all for this week. I will see you next week, same time, same place on the Money with Katie Show. Our show is a production of Morning Brew and is produced by Henah Velez and me, Katie Gatti Tassin with our audio engineering and sound design from Nick Torres. Devin Emery is our chief content officer, and additional fact-checking comes from Kate Brandt.