Sinner or Saint - ESG Investing vs. Vice Investing

ESG (or environmental, social and governance) investing is one of the hottest things in markets right now, with large fund managers competing to be seen to take ESG more seriously than the next.  Setting aside any moral judgements, the commercial rationale for the investment management industry is pretty clear: ESG funds have attracted about $350bn over the last two years, almost twice as much as the rest of the stock fund universe combined.

The opposite of ESG investing is investing in sin stocks (or vice investing) - a term for investing in companies that engage in a business or industry that's considered unethical, immoral, or unsavory.  Today we take a look at the returns for each strategy.

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ESG (or environmental, social and governance) investing is one of the hottest things in markets right now, with large fund managers competing to be seen to take ESG more seriously than the next.  Setting aside any moral judgements, the commercial rationale for the investment management industry is pretty clear: ESG funds have attracted about $350bn over the last two years, almost twice as much as the rest of the stock fund universe combined.
In the first six months of 2021, more ESG-related bonds were issued than in the full year of 2020. And while the sector still represents a tiny slice of the bond market overall, it appears to be growing quickly. More than 17 percent of bonds issued last month were labelled as being socially responsible, sustainable or green, according to Bank of America.
Saudi Arabia's Public Investment Fund has even gotten in on the ESG trend having announced that they are considering their first issuance of green bonds.  I’m sure you can do green investments in Saudi Arabia, and lots of investors would be delighted to get involved in this.  After all, Saudi Arabia is a great credit (due to all their oil wealth).  I’m not entirely sure how ESG scores work, but I imagine a country with an unelected leader who occasionally kidnaps his critics abroad, tortures and dismembers them, will lose a few ESG points. But at least they are showing a commitment to the energy transition.
The opposite of ESG investing is investing in sin stocks (or vice investing) - a term for investing in companies that engage in a business or industry that's considered unethical, immoral, or unsavory. Now historically, sin stocks were made up of companies in the weapons, alcohol, gambling, or tobacco sectors. But, with the growth of socially responsible investing and ethical investing, sin stocks now often encompass other companies and industries that people find objectionable for a variety of reasons.
Environmentalists for example might classify energy stocks as sin stocks, saying that the companies in that space are polluters. Vegans might consider any company that raises animals or sells animal products to be a sin stock. Some might even call Alphabet (the parent company of YouTube) a sin stock as people binge-watching YouTube videos are indulging in sloth. That’s crazy talk though, don’t listen to those people, and instead subscribe and hit the bell icon so that you don’t miss any of my new videos.
Different societies at different points in time disagree as to what is considered acceptable behavior. A good example is the way the Western and Eastern cultures view debt. In the Western world, incurring debt is considered a sound business practice and is even rewarded with government tax incentives. But for thousands of years in Eastern cultures, borrowing money, which implies the inability to live within one’s means, is viewed as “losing face.” In Muslim countries, it is considered a sin to pay or receive interest. So, Muslim investors can only receive dividend income, not interest income.
You might think that young investors (millennials) are leading the charge into ESG or socially responsible investing, but in fact over the last five years Boomers have moved from having less than half of a percent of their assets in ethical funds to over 5%.  Millennials have around 4% of their assets in ethical funds, and based on what I read online the rest of millennials assets are in Bitcoin, which has the carbon footprint of sasquatch.
So let's go over some of the theories around how these different styles of investing might work out in the long run.  Does ethical investing improve the world, and should an ethical investor expect to outperform a vice investor?
Well, there are two conflicting theories of how ESG investing might improve the world, but they can’t both be right.  The first theory is that investing in positive (or “good”) companies will improve the world by raising the cost of capital for bad companies, the idea is that seeing this higher cost of capital will encourage unethical businesses to shift to a more ethical, or environmentally friendly business model.
This is an appealing theory because it makes some rough sense as a matter of economics. It has problems though. For one thing, you have to have an awful lot of money invested this way to meaningfully increase the cost of capital for sin stocks. Even huge asset managers like BlackRock or Fidelity can’t actually point to unethical companies that they put out of business just by refusing to buy their stock or buy their bonds. More damning though is the fact that raising the cost of capital of sin stocks means increasing the expected returns of these securities for those who choose to invest in them.
The logic of raising sin stocks cost of capital, implies that an ethical investor in the long run will get lower returns than a sin stock investor, because ethical investors are going to push up the expected returns of sin stocks. This effect can be seen in the bond market where green bonds yield around two basis points less than comparable non green corporate bonds.
As you can imagine the marketing teams at ESG funds are not pushing the idea that they improve the world by giving you a lower return on your investments. It is just not a great sales pitch.
So, a better sales pitch might be the second one: which is that an ethical fund profits from long-term shifts to things like clean energy, healthier lifestyles, and increased regulation of business practices.
The pitch is that if you are at the front of this trend, you’ll get better returns than those who are stuck in the past investing in guns, tobacco and extractive industries that will be obsolete when regulations and societal norms change. That tells the client a good story — “you can be ethical and get rich from it too” — but, you’ll notice, that this argument does not describe a mechanism through which the investment strategy improves the world. It profits when governments move faster than expected to regulate certain industries, but the investments themselves do nothing to bring about these changes.  This argument is not that you are improving the world by your style of investment, it is instead saying that the world is changing on its own and you are investing in the future winners and so should expect to outperform.
Well, Frank Fabozzi from NYU studied the performance of “sin stocks” analyzing 37 years of stock market data from twenty one countries around the world.  He found that over the period sin stocks generated excess returns in all 21 countries studied and double-digit excess returns in 16 of them.
Another study by Hong and Kacperczyk, found that less “norm-constrained” investors such as hedge funds reaped the benefits of those extra returns, while pension plans lost out.
There are many possible causes for this performance difference. Sin stocks might be systematically cheaper than their fundamentals would suggest, just because certain types of investor avoid them. Sinful industries might additionally be facing less competition as new competitors would struggle to raise capital in today’s environment. That protection allows the existing companies to reap higher returns.
Sin stocks are exposed to risks like regulatory risk, where the business might be regulated out of existence, tax risks, where governments often increase taxes on things like tobacco or alcohol in order to reduce demand for them while raising revenue.  There are often other legal risks like the risk that a company that makes a dangerous product could be sued by a customer who was injured.  The higher returns investors make on these investments might just be compensation for taking these risks.
If you want to compare the returns of ESG investing to Vice stock investing you can compare the returns of a mutual fund called the Vice fund (the ticker is VICEX) to the returns of your favorite ESG fund. The vice fund has been around since 2002, and according to their prospectus, they make best-in-class equity investments within the global tobacco, alcoholic beverages, gaming, and aerospace/defense industries.  They have higher than average fees, but have mostly outperformed the stock market on a risk adjusted basis since inception.  The Vice fund has not done as well recently, as investments in aerospace and casinos (for example) were ill suited to the COVID19 pandemic.  Most ESG funds or indices that I have looked at are heavily weighted in technology stocks, and exclude energy stocks. This has contributed significantly to their higher returns over the same period.
Let me know your thoughts in the comments section as to which investing style you prefer. I’d equally be interested to hear what you think of the stocks that make it into ESG portfolios. Are companies like Facebook, Apple and Amazon more ethical than the types of stocks that are excluded?
See you later, Bye.