SEC v. ESG If you invest in an ESG fund—one that tries to invest in companies with good environmental, social and governance practices, and avoid investing in companies with bad ones—should you expect to outperform or underperform the market? There are at least two straightforward but opposite possible answers: - Outperform. In the long run, companies that have good environmental, social and governance practices will outperform companies that don't, because good practices are better than bad practices and sustainability is more sustainable than non-sustainability. On this theory, ESG investing is sort of like value investing: You are looking for characteristics of companies that the market undervalues, and buying those companies because you expect their market value to eventually catch up.
- Underperform. You buy ESG funds because you want to allocate capital to socially beneficial activities and not to socially harmful activities, measured not by financial results (people keep buying cigarettes!) but by some external criteria. If lots of people do this, then that will reduce the capital available for the harmful activities and increase the capital available for good activities, which will have the effect of (1) reducing the amount of bad activities and increasing the amount of good activities, which is what you want, and (2) increasing the cost of capital of the bad activities and decreasing the cost of capital of the good activities. But "cost of capital" is another way of saying "expected return": If the cost of capital of bad activities is high, then that means that the people who do invest in the bad activities should make more money than the people who invest only in the good activities. So your ESG fund should underperform the market, and in fact the way that you know that it's working—the way you know that it's limiting the capital available to bad activities—is if it is underperforming the market.
Those are the possible answers for ESG investing in the abstract. But when you do your ESG investing through ESG funds, you get at least one other possible answer, one involving agency costs: - Professional investment managers are paid to beat the market, which is hard to do. So they spend some time and effort trying to beat the market (by learning a lot, doing research, buying alternative data, etc.), but they also spend time and effort trying to make excuses for not beating the market. "ESG" is one possible excuse: If your fund underperforms the market, you can say "yes but we caused less pollution than the market so you should keep your money with us."
Of course if you underperform other ESG funds, this is harder, but not impossible. The trick is that, while investing performance is mostly measured on a single scale—did your stocks go up or down—ESG can be measured in lots of debatable ways. Maybe you underperformed other ESG funds but they were more weighted toward good corporate governance and still owned fossil-fuel stocks, while your fund was pure and free of fossil fuels, so you should get more ESG credit and the investors should stick with you. Or vice versa, whatever, the point is that there is no single objective standard of how ESG any fund is, so fund managers have more opportunities to argue that actually their fund is good. It is a somewhat unsatisfactory situation. The SEC is asking some questions: The Securities and Exchange Commission has sent examination letters to firms as record amounts of money flow into ESG funds. These funds broadly market themselves as trying to invest in companies that pursue strategies to address environmental, social or governance challenges, such as climate change and corporate diversity. … The SEC initiative is based out of the agency's Los Angeles office, according to a person familiar with the matter. It has focused on advisers' criteria for determining an investment to be socially responsible and their methodology for applying those criteria and making investments. One letter the SEC sent earlier this year to an investment manager with ESG offerings asked for a list of the stocks it had recommended to clients, its models for judging which companies are environmentally or socially responsible, and its best- and worst-performing ESG investments, according to a copy of the letter viewed by The Wall Street Journal. It follows a similar examination letter sent last year to other asset managers, suggesting the regulator decided to broaden its examination. … "This is a relatively new area," said Betty Moy Huber, co-head of law firm Davis Polk & Wardwell LLP's environmental, social and corporate governance group. "Now the SEC is saying, 'Wait, how do you know these are ESG products and that you don't have a fossil fuel company with known, poor ESG performance in there?'" … The regulator in the letter asked whether the adviser followed well-known policies for socially responsible investing, including the United Nations' Principles for Responsible Investment. What if the answer is yes? What if it's no? Imagine regulating this. Like, just, on first principles, whose policies should you use for picking socially responsible investments? You could imagine a model in which ESG funds compete to implement the particular environmental/social/governance desires of ultimate investors: Fund managers could market lots of different funds with different preferences and priorities, and people could choose the funds that best match their own preferences. If you like guns and board diversity but hate fossil fuels and cigarettes, there'd be a fund for you, or multiple funds that give different weights to those priorities. If that's the model then I suppose the regulatory goal would be disclosure: If every fund clearly explains what it values and how it ranks those things, then investors could make an informed choice among them. The advantage of this model is that ESG funds would serve the preference-aggregating function of financial markets: People would direct their money to the things that they want, and then on aggregate they'd get more of the things they want. Prices would be informative, resources would be allocated in socially desirable ways, etc. The disadvantage is that investors would have to go read through lots of disclosures to find the funds they want, or just give up, guess (incorrectly) that every ESG fund is the same, and pick one arbitrarily. Or you could imagine other models in which there'd be one, or a few, ESG standards, and "ESG" would mean a specific thing, and people who wanted that thing could buy ESG funds and people who didn't want it could buy other funds. The UN standards, for instance, or standards set by industry bodies. Here ESG would reflect the preferences of, you know, the sorts of people who devote their time to writing environmental, social and governance standards for investment funds. If you expect your values to roughly align with those people's, then you'll want an ESG fund; if you are very different from them then you might not. The advantage of this model is informational simplicity: If ESG means roughly one thing, then it is easy to learn what that thing is and to decide whether or not to invest in ESG funds, instead of having to hunt through dozens of funds to find one whose view of ESG matches yours. There is also an agency-costs advantage: If every fund is held to some external set of ESG standards, then you can evaluate who is meeting the standards and who isn't; if every fund writes its own standards then it's harder to judge. Here's SEC Commissioner Hester Peirce: "While financial reporting benefits from uniform standards developed over centuries, many ESG factors rely on research that is far from settled," she said in a speech last year to California State University Fullerton's Center for Corporate Reporting and Governance. Ms. Peirce said in separate remarks last year to the SEC's Investor Advisory Committee, "I think that should be part of the discussion, trying to figure out to what extent ESG might stand for 'enabling stakeholder graft.' " The disadvantage is that if your view of ESG doesn't match the standard view, then there won't be an ESG fund for you. The other disadvantage is that if the SEC is involved in enforcing those standards, then the SEC has to decide what is socially desirable. I doubt that's a position that the SEC wants to be in. Executive pay The dominant mode of academic corporate finance is cynicism, and the cynicism is never purer than in the executive-compensation literature. Nobody in this literature runs a public company because they believe in its mission, or because they are committed to shareholder value, or because they just enjoy the quiet satisfaction of a job well done. Everything is about incentives—money—and your CEO will spend all his time partying and robbing the company unless you structure his compensation in exactly the right way. It is an entertainingly grim view of human nature. Here's a funny paper by Meng Gao, titled "Get the Money Somehow: The Effect of Missing Performance Goals on Insider Trading," about how executives respond to performance incentives. The maximally cynical answer of course is that executives artificially manipulate corporate performance to just barely beat their performance targets and earn their bonuses. But that's old news! Anyone who works on executive compensation would just assume that any performance targets would be gamed; Gao dismisses it in a sentence. She focuses instead on relative performance targets—paying executive based on how the company performs relative to its peers—because they are harder to game: Using a sample of 1,317 relative performance grants for which the payout schedule exhibits jumps around performance goals, I first show that there is no bunching on either side of the performance goals and the density function is smooth around the goals. This pattern is in contrast to that for grants based on absolute performance goals, which are subject to manipulation by managers (Bennett, Bettis, Gopalan, and Milbourn, 2017). Because the performance goals are based on the performance of a group of peer companies, which is not observed until the performance period ends, this makes it difficult for managers to perfectly control whether their performance is above or below a relative goal in a narrow range around the goals. Fine. If you tell executives that they'll get more money if revenue is above $1 billion, revenue will be $1.001 billion due to some hard-to-observe accounting manipulation or sales trickery. If you tell them that they'll get more money if revenue is above the revenue of their nearest competitor, they can't cheat as easily. So what can they do instead? Gao: Managers whose performance is right around a relative performance goal presumably have strong incentives to improve performance because of the convexity in the payfor-performance structure. Yet, if managers are able to generate abnormal profits from insider trading when they miss the performance goal, they can reduce the effective convexity and hence mitigate the incentive effect. I hypothesize that missing a relative performance goal induces managers to generate abnormal trading profits from insider trading to make up for the loss in performance-based compensation. … Relative to managers that just beat a relative performance goal, those that just miss one earn abnormal profits from insider trading that amount to about 8% of their total compensation. … This estimate suggests that managers use insider trading to make up for over half of the loss in compensation due to missing performance goals. If you are a corporate insider you can buy or sell stock in your company, though you have to report your trades. Some executives trade for random or diversification or paying-college-tuition purposes; others buy their company's stock before it goes up and sell before it goes down. Gao finds that executives who just miss performance goals are more likely to insider trade profitably after missing the goals, suggesting that they are making use of private information about their company's performance in order to extract some extra value from the company. She writes: CEOs whose actual performance is close to a relative performance goal may treat the compensation associated with meeting the goal as a reference point and exhibit loss aversion when they narrowly miss the goal. In other words, CEOs derive utility from gains and losses relative to an expected level of compensation and the negative effect of losses in compensation on utility is larger in magnitude than the positive effect of gains (Kahneman and Tversky, 1979). Therefore, CEOs who narrowly miss a performance goal and hence suffer a loss in compensation would derive a higher marginal utility from an additional dollar of insider trading profits than otherwise similar CEOs who narrowly beat the goal. The cynical theory is something like: CEOs often have secret information about whether their stock will go up or down, and they usually don't use it because there are some obvious deterrents (insider trading laws, investor scrutiny) to using it, but when they narrowly miss a target they become resentful and start insider trading for profit. If you were even more cynical you might imagine that the resentful CEOs would also create more secret information for themselves. For instance, if a company gives (accurate) earnings guidance, the CEO is less likely to know more about upcoming earnings than the market does, so it will be harder for her to make money by insider trading. But she could stop providing guidance: I find that relative to managers that just beat a relative performance goal, those that just miss one are less likely to provide earnings and sales guidance, suggesting that managers strategically withhold information to increase their informational advantage. The economic magnitude of this effect is large: For example, the difference in the likelihood to make voluntary guidance disclosures between firms that narrowly miss and those that narrowly beat relative performance goals is 28.0 percentage points, which is large considering that the mean likelihood of providing guidance disclosures is 67.3% in the full sample. Look I … I don't really believe that lots of corporate CEOs narrowly miss their performance targets and are like "fine I'm going to stop telling investors anything, so I can make a lot of money insider trading against them and make up for my missing bonus." The schematic cynical view of executive motivation is a bit too cynical even for me. But it is what the theory, and the data, suggest. Uber out In a sense Travis Kalanick is just some guy who happens to own a lot of Uber Technologies Inc. stock. He owns that stock because he founded Uber and was its chief executive officer, but now he's not, and he hasn't been for a while. Because he was the founder, he had a lot of the stock before Uber's initial public offering in May. If you are the visionary founder-CEO of a growing startup, you are supposed to own a lot of the stock; your wealth is supposed to be vast but undiversified, to signal your commitment to the company. But for anyone else, having all of your money in one stock is just kind of weird. If you don't control the company anymore, you shouldn't keep all of your money in that company out of sentimental attachment; also it is not clear that the sentiments between Uber and Kalanick are all that warm. (He remains on the board of directors though.) So Kalanick is sensibly selling his stock. When Uber went public, Kalanick owned about 117.5 million shares of its stock, worth about $5.3 billion at the initial public offering price. He sold a few million shares in the IPO, but then the IPO lockup prevented him from selling any more shares for six months. The lockup ended in November, and since then he has been busy: The Uber Technologies Inc. co-founder unloaded $350 million more of stock this month, bringing his proceeds to more than $2.1 billion since a share lockup ended Nov. 6. The 43-year-old's remaining stake in the ride-hailing company now constitutes about a fifth of his $3 billion fortune, according to the Bloomberg Billionaires Index, down from about 75% before the lockup. There is nothing particularly strange about this. At one point—basically before June 2017—Kalanick was the founder-CEO of Uber and owned an appropriate amount of stock for a founder-CEO, and now he is not the founder-CEO and is working his way down to an appropriate amount of stock for a non-founder-CEO. But because of the mechanics of selling stock in a private, and then a newly-public, company, Kalanick couldn't really start working his way down in a big way until last month. And now he is making up for lost time. The SEC website lists all of his sales, and it is quite a list. He has sold stock every day since the lockup expired. He has accounted for about 7.8% of Uber's volume during that time; one out of every 13 shares sold in the last five weeks were sold by Kalanick. It is just odd to see this transition as it happens. In a sense Uber's IPO is still happening; it is still transitioning from its private ownership structure to its long-term public structure, a few million shares a day. It is slower than the actual IPO, but still pretty fast. At this rate he should be done by the end of the month. Things happen Goldman unveils Blackstone-like investments group. PG&E Removes California Governor From $13.5 Billion Fire Deal. Three London Bankers Face Trial in Germany Over Tax Scandal. Hottest Job in Argentina: Helping the 1% Hide Their Cash Abroad. PwC Clients More Likely to Revise Financial Statements. SEC Is Expected to Propose Further Loosening of Auditor Independence Rules. Aramco Shares Dip for First Time Since Last Week's Record IPO. Samsung Chairman Sentenced to Jail for Violating Labor Laws. Fed Alumni Fear Crisis Risk in Simultaneous Cuts to Rules, Rates. ISIS Is Experimenting with This New Blockchain Messaging App. Chess champion Magnus Carlsen moves to top of world fantasy football rankings. "Now, it's gonna taste terrible, likely. But that's a totally different situation." "As far as I was concerned, all our fish was sourced from the same place: the freezer." "You're My Present This Year": An Oral History of the Folgers Incest Ad. If you'd like to get Money Stuff in handy email form, right in your inbox, please subscribe at this link. Or you can subscribe to Money Stuff and other great Bloomberg newsletters here. Thanks! | 
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