Would You Sacrifice 'Evil Stock' Returns for the Sake of Sustainability?
Cliff Asness, hedge fund manager and the co-founder of AQR Capital Management, talks about ESG investing and today's private equity market.
Cliff Asness joins The Long View to discuss his work with his colleague Antti Ilmanen, future expected returns, value investing, and his latest thoughts on ESG and private equity.
Here are a few excerpts from Asness' conversation with Morningstar’s Christine Benz and Jeff Ptak:
Benz: I wanted to ask about ESG investing, which is the theme, I think running through a lot of these sessions at this conference, you've written about the mechanism by which ESG investing can effect positive change. It relates to preferences, cost of capital, hurdle rates and the projects that firms not to pursue. Can you explain that thesis?
Asness: This was not my most popular piece. And I thought it was actually pro ESG. Because I thought I was explaining how ESG might really change the world. And I say might because no one's really done a good job of calibrating the size of these effects. But I do think a lot of ESG investing and here I'm talking about the form that doesn't own or owns less of, or even in our case, shorts, "bad guys." There's another form of ESG, I'm not going to touch on, that's about engagement, where you are an owner of a bad guy, and you try to make him into a less bad guy.
Now, you may notice one form of ESG, here underweights or shorts the stock, and the other form has to go long the stock because you don't get a lot of influence over say, a board, if you don't own the stock, these are not as mutually exclusive as they sound some people can pursue one, some can pursue the other, but let's deal with the most popular form of ESG that says we're going to define somehow and I'm leaving that undone here, the bad guys. And we're going to tilt the portfolio away from those bad guys either, with complete divestment as far as we go is shorting. We do have a, feel very strongly shorting can play a role there. But even underweighting, it can be a factor in what you do. I want to own less of the bad guys, but up to a point, I don't want to take more than this risk.
Question for a lot of those people. And I think a lot of people frankly, just haven't thought about it is all right, this feels good. Feels like I'm doing the right thing. But how am I actually changing the world? Got to remember. And again, I'm not telling them what their goals should be. I'm not a commercial for this. I'm not criticizing it, I'm taking it as a given that my client's goal is to change the world. How does their actions do that? Well, if you, if you and it's much better if it's a lot of yours, one person owning a little bit less of something isn't going to change, but if a decent amount of the market owns less of, won't own or even shorts the bad guys. Markets have to what's called clear somebody else owns those stocks. And they own more than they wanted to before this. If my two friends here are really nice people who won't own any of the evil stocks, and I don't give a damn, I just want the money.
I own as many evil stocks as I think is optimal. Now they want me to own more because they're selling theirs, I say because I'm the evil guy. Remember that. I say yes, sure. But there's a price, I'm not going to own it at the same price or expected return going forward. Because the opposite of a price is an expected return, you have to induce me to be undiversified to take a bigger risk in being concentrated in what you don't own. Now, there's a really painful part of this. That makes if I'm right. And I really, really am. Just to be clear. I don't know how big the effect is. That is still being fought over.
But if we are right about this, the expected return on the bad guys is now higher, because that's what the bad investors demanded to be in. And that is a painful thing. If you're an ESG person, it's not fun to know that the people who are taking the other side make more. But what does it mean to have a higher expected return? Well, I know a lot of you took these classes in an MBA program somewhere, the opposite of an expected return is a cost to capital. When you sit there with your spreadsheet, with your negative cash flows up front, turning positive at some point and then getting very big positive because you love this project, and you discount it back at some discount rate. And if it's a positive NPV, your teacher says you should do that project.
Well, quite simply, if the discount rate or expected return is considerably higher, you do fewer projects, you don't do fewer projects, because you suddenly become a good guy. You do fewer projects because fewer can cross your hurdle of what you need to make to be, to add value to your company. So that's how you affect the world. The bad guys face a higher cost of capital and make less and do less. There are people in the ESG world who hate this story. Because I think and I'll be very frank with you. I think too many people in the ESG world have sold it as you will do wonderful things and feel wonderful and you'll make much more money. Who doesn't want that? It may be true in the short term, if you view ESG as a trade, by the way, there's nothing wrong with saying, I think there's going to be a big movement the ESG. So at this point in time, I do think ESG is going to overcome this discount rate effect and, and make more money. Because that's flows based argument.
The cynical side of me, which is actually both sides of me, says that very well might be true. But the bad people would do the same thing as the good people there. Because if they agree on the facts, they place the same bets, that means you're doing the trade to make money. The title of this piece was a little condescending, I admit, it was Virtue Is Its Own Reward. It's like you shouldn't be expected to be paid tons of extra for doing the right thing. In fact, I think it is actually a very small give up. I really doubt it's a very large one. But you may even have to give up a small amount of expected return to change the world. That's the argument. And now everyone hates me.
Ptak: Wanted to shift and talk about private equity, which you mentioned earlier in the conversation. I think you and your team have put forth the idea that investors and private securities don't actually stand to earn an excess return compared to public securities. If I'm not mistaken, but instead they must accept an illiquidity discount, that discount representing the returns that they forego in exchange for the lower volatility private securities tend to exhibit. Can you explain why investors would prize lower volatility so much that they'd overpay for it?
Asness: Sure. First, you're probably right in what I actually think. But in the piece, I was a little more careful. It was a conjecture. I don't actually know where it comes out. And I'll explain, but I'm pretty sure I know the direction. So imagine, and this is going to be too clean of a story. It's always a combination. But imagine 25 years ago, a private equity investor was about the returns in the alpha. Well, to get those returns in alpha, they generally own. This is a broad generalization it won't apply to everyone. But it's not uncommon to have a decently levered portfolio of small and mid-cap stocks. They are illiquid firms, by definition, they're privates. You have to have a buyer by appointment with lots of lawyers, and whatnot. The fund itself is illiquid to its investors. Pretty basic theory, or even common sense, would say, well, illiquidity is bad, right. So I should get a premium in return for being willing to accept this illiquidity.
And then everything's copacetic I get paid a little for it, though, if I really need the money. I'm in more pain, because it is an illiquid asset. So I'm taking a risk to get it. I do think over like the next 25 years. And again, it's not necessarily clean, even 25 years ago, people might have been thinking about this. But there are two other properties to private equity. You can't sell it. There's a secondary market sometimes, but you'd get your face ripped off, you mainly can't sell it. And even more important, very rarely, and at a big lag and not as extreme as it should be do they market to market. So it is really easy to live with. I resent this highly. It's a mathematical fact that I resent. And when you resent mathematical facts, you're tilting it obvious windmills, but call them levered mid-cap. They move around like crazy.
I have a story I'm going to make you listen to, it's short. This is 1997 some of you weren't born. I'm aware of that. We had something called the Asian debt crisis. It was one of the more minor crises in 30 years of a lot of crises, but the S&P 500 was down 7% in a day, and that was after a fairly long, calm period, so it felt even worse. All over, I was at Goldman Sachs at the time doing early precursor to what we do today, the head of Goldman Sachs, Jon Corzine, went on to be Senator, Governor and then had a tougher time, in a different role, but great guy came by, looked at our screen, and it said, we were like up 5% in this market neutral thing we'd only been doing for a few years. And that would be great, because we were making money in a bull market. So it's not that any one thing proves anything, but kind of an acid test markets way down.
Unfortunately, he was looking at the screen, which we knew was wrong. The screen was wrong, because one of our big trades at the time was short the U.S. and long Europe. It was late in the day, how to look really smart. Be short a market that's crashing and long a market that's closed. Your P&L system looks wonderful. We had actually done guesswork, you know, what if it opens up moving with its beta tomorrow, similar to the U.S. and we said we'd be about flat, which we thought was a home run after making money. But you can't take a man from up 6% to flat and have him still be happy. He was like, I guess it was probably the best thing he had going that day. And he was like, yeah, flats okay, whatever.
So then the head of our private equity comes by, and I'm manning the screens now. So, he says, how you doing? And I say we're flat. And he says, Oh, that's great. Me too. And I go, because I was shy and understated, even back then. I said, no, you're not. He said, what do you mean? I go, okay, if you had to sell your whole portfolio yesterday, I don't mean a fire sale. But if you did it, if yesterday was the sell date, versus today, wouldn't you get way less today? Again, aren't you leveraged stocks, and don't they just move the multiples with the market. And to his credit, he said, oh, way less. But we don't have to sell today. And no one's writing the number down. And that was my first experience with going a, this is kind of crazy. They're not less volatile than us. They just don't tell you about it. But b, to be nice to them. If the investors are doing it with open eyes, just because it makes them better investors, it can long term add to their welfare. If there was a way to invest in AQR where we only told you the results every 10 years. And you couldn't get out anyway in between? I think we do better for you. I think every manager thinks they would do better for people if they had that deal. But I think the reasons are obvious. Doesn't exist. It turns out every like five years, someone at our firm says, can we build something like that?
And it turns out that if you actually can look up the prices to the second on Bloomberg, it is quite illegal not to tell people about that. But if you can't look them up, it is kind of an out. So over time, I think this property. And if you talk to people in the institutional world, investing in privates, or the private equity managers themselves, if they're not doing a public presentation, and if you have at least two drinks with them, I don't golf, but they all golf like crazy. So maybe after 18 holes, they'll tell you this is true, that people really value this ability to hold it, which really amounts to I can't see you, I can't hear you what it is again, volatile, you just can't see it.
Now here's I'm finally getting to the answer. If people are valuing this property, remember, this is a property we used to think was a negative, you can't have the money back when you want. It's illiquid. And we can't even tell you what it's really worth. If that was a presumed negative, you needed to be paid extra to bear it. And again, I don't know how far this goes. So I'm not willing to say it's now much worse, but directionally if now a big part of why you want a lot of privates is they're easier to live with. Well, if that's a good property, you pay for good properties, you get paid to bear bad properties. So if you go again, it's anecdotal. It's not great data on private equity.
Private equity managers will tell you, there used to be three people looking at every deal. There are now 15. And the IRR is which is kind of a look at the world a little different, are considerably lower, even compared to public markets than they used to be. So I am never 100% confident but I'm very confident we're right in direction. That privates are being more prized today, at least on a relative basis compared to the past for their hiding of the risk. They're hiding with open eyes. No one's really being fooled here but their ability to hide the risk. And if that's true, people used to be paid a premium. And they're now giving up something to be in it versus the similar aggressive equity portfolio.
By the way, it could still be the right call for these people, if it allows them to take considerably more risk, even if they have negative alpha to the public markets, if they can take more risk on average, and stick with it, and not sell it at a terrible time. They could still be right. But it will still irk anyone, and I'm assuming many in this room will have to mark their market portfolio to market every day. I'll tell you AQR had a terrible '18 through '20 and a wonderful last year and a half. And if we were private equity, none of it ever happened. We just well markets were a little bit lower at the end of 2020. But it all came back, and you know, nothing to see here. So with everything I say about privates. I do think I'm right. But you should discount a little bit by my professional jealousy of the deal they get.