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Rekenthaler Report

The Best Investment Politics Is Strong Performance

The safest way to deliver that performance is through indexing.

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Rise and Fall

Once upon a time, there was Stein Roe Young Investors Fund. Launched in 1994, the fund was positioned as an educational tool. It owned companies that were familiar consumer brands--no faceless suppliers or boring business services, but instead everyday names like Coca-Cola (KO) or Disney (DIS). Parents would buy the fund for their children, who would then learn about investing by tracking the businesses they owned.

The fund got off to a roaring start. It gained almost 40% in 1995, nudging past the S&P 500, then beat the index by a full 12 percentage points the next year. After a couple of profitable but index-trailing years, it surpassed the S&P 500 once again, besting the benchmark by 10 additional percentage points in 1999. Sales followed suit. The fund ended the decade possessing $1.3 billion--not much by today’s standards, but a tidy sum for a 20th-century boutique firm.

You can guess how this story ends, given that you either cannot recall ever coming across Young Investors Fund, or, like "Ben Kenobi," it’s a name you’ve not heard in a long time. The fund subsequently trailed the index for five straight years, which led it to being merged out of existence.

Socially Conscious (and Unconscious)

Strictly speaking, Young Investors wasn’t a “political” fund, but it appealed to people from similar backgrounds who shared similar views--an activity that, if successful, would bring wealth and power to the organizer. That sounds a great deal like a political campaign, does it not? At any rate, the point applies equally to the socially conscious funds of the 1980s and 1990s, which were overtly political. Such funds received major attention only when their returns were high.

Such has also been the case with that avowed opponent of socially conscious funds, USA Mutuals Vice Global Investor (VICEX), a black-hat offering that invests in companies that sell alcohol, guns, gambling, and tobacco. (The fund inevitably reminds me of the quote from Manchester United’s George Best, who reminisced, “I spent a lot of money on birds, booze, and fast cars. The rest I just squandered.”) It initially attracted those who wished to thumb their noses at socially conscious funds, but eventually its assets rose and fell with performance.

The ESG Movement

Such funds were always destined to occupy the industry’s fringes. However, over the past decade a new breed of political fund has emerged that carries much greater potential: funds based on environmental, social, and governance principles. The ESG movement is global and is embraced by various government bodies ranging from national to regional to local. It is here to stay.

Among U.S. retail investors, such funds are attracting investors rapidly, albeit from a modest base. Morningstar estimates that “sustainable” mutual funds and exchange-traded funds (sustainable being Morningstar’s term for funds that follow ESG precepts) attracted $51 billion in net new assets during 2020. That represented a hefty 23% of incoming sales, which is terrific. That said, ESG funds control just 1% of existing industry assets.

Still, the trend is impressive. However, these are the easy times, the equivalent of Young Investors’ early years. The story has been told, and the interest sparked. A 2020 survey by IBD/TIPP of U.S. households with at least $10,000 in stocks or mutual funds found that most respondents had not yet heard about ESG investing. However, among the 30% who did profess to know something about ESG principles, 79% replied that ESG rankings “merited consideration.”

Encouragingly for fund companies adopting the long view, enthusiasm rose markedly as age declined. Among the 30% who claimed at least some familiarity with the ESG movement, a whopping 91% of respondents aged 44 years and younger stated that ESG rankings were an “important consideration.” That’s as close to unanimous as investment polls get.

From the perspective of ESG promoters, so far, so very much good. Retail investors who know about ESG principles tend to approve, particularly if they are younger. What’s more, another 70% can potentially be converted to the cause. Relatively few investors have rejected ESG principles outright. Most who don’t own ESG funds have missed the opportunity through ignorance, not choice. With more education, they will be permitted that chance.

Performance Matters

There is a catch. The IBD/TIPP poll also asked which factor was more important for companies, 1) improving social welfare through actions like protecting the environment, offering fair wages, or providing a safe work environment, or 2) increasing profits by raising their returns on invested capital. Respondents consistently chose the second option, by a 2:1 margin. If push comes to shove, most investors will choose higher stock prices, thanks very much.

Proponents of ESG argue that push will not come to shove, because sustainable investment practices lead to better total returns. That may be, but it should be noted that if ESG performances are superior, most shareholders of ESG funds will not hold their fund for political reasons. They will do so because the fund excels at its core task of delivering high investment performance. Its politics will be a “nice to have,” but not the driver of most investors’ buy/sell decisions.

It is for this reason that I believe most ESG monies eventually will land in one of two versions of index funds: 1) enhanced and 2) activist. Enhanced-index funds will keep their returns close to that of the benchmark by investing across all U.S. industries, while selecting businesses that follow the best ESG practices (that is, the most sustainable energy companies, the most sustainable gold miners, and so forth). In contrast, activist index funds will own everything, then use their proxy votes to pressure the firms they hold into improving their ESG compliance.

In Conclusion

To be sure, some actively managed ESG funds will post consistently strong returns, thereby becoming megafunds. Such feats are inevitable, but, if the recent history of conventional funds is any indication (and I think it is), regrettably rare. Most funds that have succeeded in convincing investors that they are not missing out on better performance have done so through indexing. The same likely will hold for ESG funds, too.

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

John Rekenthaler does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.