Environmental, social and governance (ESG) issues have come to the forefront of investment practices over the years. However, a critical concern for investors is the lack of quantitative standards in defining ESG rankings. In fact, many firms are changing their ESG guidelines to add defense stocks for the first time.
In a recent interview with ValueWalk, Mark Neuman of Constrained Capital explained that there is no rhyme or reason to how ESG rankings are assigned to companies. This fact is further evidenced in changes to the ESG guidelines for defense and weapons stocks. Constrained Capital is an investment manager attempting to capitalize on distortions caused by participants divesting in areas like ESG investments.
ESG Standards In Flux ZEL
Neuman observes that when the war in Ukraine broke out toward the end of February, stories appeared regarding changing the taxonomy of ESG investing to potentially include defense stocks because of the “S” component, signifying societal impact. He believes ESG experts have considered changing that taxonomy at other times over the years to allow for a broader definition of what is included in the ESG ratings.
When he originally started looking at the ESG industry, the found manager found eight to 10 ratings agencies, including ISS, Sustainalytics and Bloomberg ESG. However, this number has now ballooned to almost 20. Digging deeper into those ratings firms revealed wildly different methods of calculating each company’s rating in all three components.
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“In my research, I discovered that E, S and G ratings by any of the many agencies varied from company to company,” Mark says. “For example, I might find an E rating on a certain company in the lower-middle-top-quartile-type of distribution, depending on which rating agency. There is little consistency across ESG ratings.”
He added that all these different ratings have created significant confusion for investors. That confusion increases with talk about changing the rating system and how a company may be considered more ESG-friendly over time, which also varies by rating agency.
“Nobody really knows rules what’s allowed and what’s not,” Neuman says. “After examining the rating system, I’m concerned from a risk standpoint that if we look back on the 2007-2009 Global Financial Crisis, we remember that CDOs that were rated AAA were actually complete junk. So who made out? Wall Street issuers. Who suffered? The market and the investors. Now we have a similar pattern with rating agencies currently captured by Wall Street.”
According to Mark, the issue is the many gray areas of ESG. He does believe the concept of ESG is a good one, but he also thinks Wall Street has turned it into an “amorphous blob.” He noted that Wall Street keeps issuing and reissuing more and more ESG funds that aren’t helping anyone but the firms and managers that create them.
Neuman notes that all those ESG funds enable managers to collect more and more assets and fees. However, he also blamed ESG for the inherent buildup of risk he sees.
“You can see it clearly at the gas station and the grocery store,” Mark opines. “Macro factors like food and energy insecurity were created by ESG starving fossil fuels and nuclear energy from everyday business. The ESG movement happily continues to say eliminate fossil fuels and nuclear energy from everyday business. The ESG movement happily continues to encourage eliminating fossil fuels and nuclear energy, which creates a vital upheaval on some level.”
He looked at all the areas shunned by ESG, including weapons and defense, fossil fuels and the nuclear space in utilities, and found that all of them were “very reasonably valued” to some degree versus the S&P 500. Tchnology, communications and healthcare have been the three biggest beneficiaries of ESG inflows.
Defense And Fossil Fuel Stocks As ESG
In light of the current events affecting the globe, opinions about what should and shouldn’t be included are in flux. In particular, Russia’s invasion of Ukraine put the traditional ESG views of weapons companies and fossil fuels under the microscope.
Neuman believes defense stocks have now become “apolitical,” meaning not blue or red, Democratic or Republican. In addition to the war in Ukraine, he pointed out that the growing conflict between Taiwan and China is also a factor for defense stocks. While Democrats have traditionally been against defense spending, Bernie Sanders called out China for its ambitions in potentially seizing Taiwan.
“These are now vital securities with national interest,” the fund manager says. “Everybody is on board to some degree.”
He also pointed out that nuclear energy remains important as well, not only for renewable energy but also for use within the military on submarines and aircraft carriers, both of which can stay out at sea for extended periods when utilizing nuclear power.
“These two vital sectors are intertwined now,” Neuman explains. “Let’s take a half-step back. We have the Biden administration taking about weapons being green… It’s going to be Raytheon, Guidant and Lockheed Martin LMT developing whatever acceptable weapons we’re willing to produce. That aspect is lost in the shuffle.”
He also pointed out that when Washington sends aid to Ukraine, Kiev isn’t buying pickup trucks. They’re buying weapons like NASAM battery systems from Raytheon, one of his “ESG Orphans.” They’re not buying from Russia.
“I think it’s an apolitical, vital issue,” he added. “I’m strictly a CFA CFA charter holder with the fiduciary, moral duty to help investors find the maximum return opportunities. I’m not playing politics.”
People often ask Neuman whether he is anti-ESG, and he emphasized that he is not. He does what he can for the environment outside the world of investing, like not using plastic bottles or supporting his son as he went to Peru to plant samplings on a service trip. he believes if everyone planted more trees, we would have a much nicer environment.
“We live a very ESG life locally,” he added. “We eat leftovers. We don’t throw away anything and recycle everything. We eliminated 99% of plastic bottles in our house. I ski, scuba dive and walk in the mountains with my family and our dog. We like those things and believe in ESG, but as an investor, the capture by Wall Street of ESG investing has turned it into something unrecognizable.”
Neuman argues that ESG detracts from investor returns, especially via the higher fees investors pay for those ESG-focused vehicles verses the lower fees on other types of investment vehicles that generate similar returns. He also sees significant amounts of risk inherent in the constant recycling of ESG stories.
Recalling a well-known quote from Peter Lynch at Fidelity, who advised investors to know what they own, Neuman said he doesn’t think ESG investors know what they own. For example, he pointed out that Amazon AMZN is a top-three holding at BlackRock’s BLK and Vanguard’s ESG funds. However, while he sees it as a “fantastic investment for some investors over history,” Amazon has the biggest carbon footprint in the world. Thus, he doesn’t think it should be an ESG investment.
“There’s a great deal of picking and choosing going on, and it’s incongruous with living a clean, ESG life, leading to misdirection,” he added.
The fund manager emphasized that most common ESG names are “excessively over-owned and crowded,” while those stocks shunned by ESG are “excessively under-owned.” He believes when investors seek out those underinvested, under-owned stocks, it provides a nice balance to their portfolio construction. He adds that he doesn’t intend to start a political discussion but rather to help investors steward their money to where their returns should be better than the average standard.
Why ESG Has To Change
He also pointed out that others have started to push back against ESG — using litigation to do it. For example, Florida Gov. Ron DeSantis decided the state’s pension funds would no longer use ESG guidelines to invest.
Additionally, multiple state attorneys general have asked BlackRock to explain its positioning. Using its Employee Retirement Income Security Act, better known as ERISA, the Dept. of Labor has also begun to question ESG in the fiduciary role and how it impacts monetary returns versus pure altruism with no concern for returns. The Supreme Court also told the Environmental Protection Agency that it might be overstepping its bounds in telling corporations how to behave.
“ESG as we know it is going to have to change,” Neuman adds. “I don’t think it’s a binary, on-and-off switch. It’s more three-dimensional. In some areas, it will expand or contract. People will change their classification system to try and allow for a broader basket of investments, but I believe the ESG landscape is a major industry with assets well into the trillions and regulatory and services fees and revenues now in the billions.”
Mark is concerned that for many participants in the ESG ecosystem, their livelihood depends on the continuation of ESG. As a result, he believes their concern may be more about prolonging ESG using the explanation that it’s for the environment or for society.
However, Neuman’s observations and research have suggested that ESG objectives are failing investors. He also warned that some of the largest ESG fund operators may care less about ESG and more about collecting assets under management and raising fees.
Thus, Neuman advises investors to be careful, protect themselves, and find a smart way to manage their risk if investing in ESG. He also believes investors should hedge their ESG investments, which is why he created his ESG Orphans exchange-traded fund. The ETF consists of stocks that have been shunned by ESG funds. It allows investors to hedge against the risks involved in ESG-heavy investment vehicles, which generally contain very crowded names.