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Money Stuff

Picking the Good Stocks Isn’t Enough

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By Matt Levine

September‎ ‎12‎, ‎2019‎ ‎12‎:‎00‎ ‎PM

ESG

In general there are two ways to make money investing in public stocks:

1. Figure out which stocks are going to go up and buy them, or

2. Buy some stocks and push the companies to do things to make their stocks go up.

I think it is fair to say that, for a long time, the normal approach for most institutional investors was to focus on No. 1 and ignore No. 2. Your expertise was in analyzing stocks and picking the ones that will go up, and you mostly did that. You didn’t tell executives at the companies you owned how to do their jobs, both because you figured they knew that better than you did, and because it might interfere with your main job: If you annoy executives, they will give you less information and you’ll have a harder time picking stocks. 1 Telling companies how to run their businesses was a niche left to specialists called “activist hedge funds,” and while big respectable institutions would occasionally get involved in activist battles, they did so uncomfortably and reluctantly.

That seems to have changed in recent years, and now there is more of an expectation that regular old institutional investors will be more involved in monitoring the companies they invest in. Not a ton more involved, but a little more; they have to think about and justify their stewardship a bit more than they used to. This change has occurred for a variety of reasons—changing social and political norms of corporate engagement, academic theories about governance, effective persuasion by activist investors, rules about shareholder voting on “say-on-pay” and other topics, the rise of shareholder proxy proposals, etc.—but one obvious big one is the rise of passive investing.

If you run an index fund, you are not in the business of picking the stocks that will go up. That doesn’t necessarily mean that you are in the business of pushing companies to do things to make their stocks go up. You could quite reasonably take the view that the whole point of an index fund is to do neither thing, to be a low-cost provider of generic access to the stock market and not expend any effort on picking stocks or lobbying companies or anything else. But in practice, you know, there you are, going to your office every day; you need to fill your time somehow. You want to be able to justify your existence, to explain to people—customers, or maybe a broader audience—why you are adding value to society. Jack Bogle could convincingly say that he invented a way for ordinary investors to save billions of dollars, but the second wave of index-fund moguls can’t quite say that, so they devote some time to pushing companies to be socially responsible or long-termist or whatever. 2

While I have been talking about approaches to making money in public stock investing, you might have different goals for your investing, and you can apply exactly the same analysis to those goals. For instance, if you run a fund that focuses on environmental, social and governance (“ESG”) factors, and if you advertise yourself to investors as an ESG fund, you could:

1. Figure out which stocks are good for the environment, etc., and buy them, or

2. Buy stocks and push the companies to do things that are good for the environment, etc.

In principle you could imagine an ESG fund that, for instance, only bought stock in fracking companies and then single-mindedly lobbied them to stop fracking. In practice that is not a viable approach. 3

On the other hand, you could very easily imagine an ESG fund that screened stocks based on some list of ESG criteria, bought the ones that scored the best, and called it a day. That seems to be the norm, really; “ESG fund” traditionally kind of means “fund that doesn’t invest in tobacco or gun or fracking companies.”

But even companies that score relatively high on a list of ESG criteria could be better. And just as the norm in regular investing has shifted a bit, with institutions now expected to be more actively involved in the companies they own, so it is becoming awkward for ESG funds to just pick ESG stocks without actively pushing them to be ESG-ier. Or, anyway, here is a funny story from the Financial Times about ESG funds that don’t vote for ESG-ish shareholder proposals:

For environmental and social proposals that received strong support from investors, six BlackRock sustainability funds voted with a company’s management 72 per cent of the time. … At Vanguard, two ESG funds, which combined have almost $7bn of assets, voted with management on environmental and social issues 93 per cent of the time when the proposals won support from at least 40 per cent of investors. ...

State Street’s gender diversity ETF, and State Street funds broadly, frequently voted in 2019 for shareholder proposals supporting political spending disclosures, Morningstar said. But the ETF, which is sold under the “SHE” ticker and has $296.8m of assets, abstained from a gender pay gap proposal at Mastercard and voted against a proposal for disclosure about gender, race and ethnicity pay equity at The TJX Companies, according to the 2019 SEC data.

That “SHE” fund advertises that it invests in “companies with the highest levels within their sectors of gender diversity on their boards of directors and in their senior leadership.” It picks companies with a lot of female directors and executives, and then it buys their stocks. But now it is apparently also supposed to vote for more gender pay gap disclosure.

I am sort of sympathetic to the implicit laziness of the traditional approach: Arguably making a list of stocks that are good on some criteria, and then buying those stocks, is a valuable service, and evaluating and supporting shareholder proposals is a different and lower-value service. (These proposals tend to be non-binding, and to call on companies to produce reports rather than make substantive changes.) Still if people want their ESG as an all-inclusive bundle, it seems silly not to give it to them.

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1.   This norm probably developed before Regulation FD, back when getting material nonpublic information from executives was a reasonable way to pick stocks. Now it is … still …that?

2.   Also, if you run an index fund and a company in the index is obviously terrible and lighting shareholder money on fire, you can’t sell your stock, so the only way to preserve your investors’ money is by telling the company to knock it off. When exit is not an option, you have to rely on voice.