Can Calpers Live With Responsible Returns?

It turns out that mutual fund managers have had no more success with ESG investing than the ESG Index. The group with the highest ESG exposure returned an average of 1.1% annually over the last five years and 2.3% annually over the last 10 years. The group with the lowest ESG exposure, on the other hand, returned an average of 7.3% annually over the last five years and 5.6% annually over the last 10 years. The middle three groups fell in line — as their ESG exposure increased, their average return decreased.

ESG investing is still in its infancy, so we shouldn't make too much of its short history. But what if turns out, contrary to Calpers' belief and our intuition about ESG investing, that ESG investing is no free lunch? In other words, that the cost of an ESG-friendly portfolio is lower not higher investment returns. There are two appealing hypotheses that suggest that this may be the case. First, ESG investing expands the available pool of capital for companies with high ESG ratings, and contracts the available pool of capital for companies with low ESG ratings. It stands to reason that, in order to compete for capital, companies with low ESG ratings must hold out the promise of higher expected returns — similar, for example, to the way that investors expect a higher return from junk bonds versus investment grade bonds, or from value stocks versus growth stocks. Inversely, high ESG ratings would be associated with lower expected returns.

Also, companies attempting to raise their ESG ratings may exit frowned upon businesses such as alcohol, tobacco, or gambling — you know, all the fun stuff. This would, of course, reduce competition in those businesses and thereby increase profitability for the remaining players. The likely result for the remaining players is lower ESG ratings but higher stock prices.

As a fiduciary, Calpers must consider whether ESG investing is likely to be a drag on investment performance, and ESG investing's wobbly start may explain why Calpers is attempting to promote good ESG policies through activism rather than divestment.

But if it turns out that the cost of ESG investing is subpar returns, it's not at all clear that activism is the antidote. By improving the ESG practices of the companies in its portfolio, Calpers may unintentionally compromise its investment returns over time.

None of this is to say that companies' ESG practices are unimportant. On the contrary, it is in our collective interest to promote the most ethical corporate behavior. But if there is a price to pay for ESG investing, Calpers may have to find another way to demand the best of its portfolio companies.