Send this article to a friend:


Capitalism, Socialism and ESG
Rupert Darwall

Big claims are being made for ESG (environmental, social, and governance) investment strategies: ESG will reconcile society to capitalism while making investors—and Wall Street—more money.

BlackRock, the world’s largest fund manager, is pushing ESG as part of a marketing pitch to millennials, who put “improving society” ahead of “generating profits.”1 Much of the buy-side pressure for ESG comes from state and municipal pension funds playing politics with taxpayers’ and pensioners’ money, many of which are in poor financial shape.

Contradictions abound. “G” for “governance” supposedly stands for enhanced shareholder control, but the thrust of ESG is to dethrone shareholders in favor of “stakeholders.” ESG investing shrinks the uni- verse of stocks that can be invested in, defying modern investment theory, which emphasizes portfolio diversification; yet somehow, we’re told, ESG will boost investor returns.

Same initials, different meaning

ESG means different things to different people—and even to different ESG ratings agencies. Tesla has been rated best, worst, and middling by three different ESG raters (MSCI, CLSA, and Sustainalytics, respectively) for global auto ESG at the same point in time.2 A May 2020 MIT Sloan working paper finds the correlation between ESG ratings across different providers is around 0.3. With credit ratings, the correlation between S&P and Moody’s is around 0.99, demonstrating extremely high consistency and agreement among raters.3

ESG ratings can make ESG-favored stocks more risky. In June 2020, ESG rater MSCI gave UK fast-fash- ion retailer Boohoo a AA rating and an 8.4 out of 10 for “supply chain labor standards.” Allegations then emerged that workers in Boohoo’s UK supply chains were being paid as little as £3.50 ($4.14) an hour. The shares promptly lost a third of their value as sustainable funds dumped the stock. “Clinging to pseudoscientific scoring systems in the face of common sense is one habit the [sustainable investment] industry needs to change,” the FT’s Sarah O’Connor commented.4

The contrast with ethical investing

ESG emerged from the ethical investment or Socially Responsible Investing (SRI) movement. Ethical in- vesting was originally a prohibition: thou shalt not profit from business harmful to one’s neighbors, John Wesley, the founder of Methodism, exhorted his followers. The first SRI fund, Pioneer Investments, began in 1928 as an ecclesiastical fund committed to Christian values emphasizing “the avoidance of morally questionable investments, not the pursuit of better risk-adjusted returns.”5

In the 1980s, SRI morphed into an activist divestment campaign directed against South Africa’s apartheid regime. A 1999 analysis found little evidence that firms hit by sanctions and legislative actions performed unusually poorly in the 1980s. In particular, the study found no discernible effect on the valuation of banks and corporations with South African operations or on South African financial markets. Overall, the study concluded that the South African boycott had “little valuation effect on the financial sector.”6

Self-evidently, the purpose of the South African divestment campaign was political. By contrast, ESG advo- cates frame the case for ESG in terms of maximizing risk-adjusted investor returns. “Voluminous research has shown conclusively that businesses properly integrating ESG factors into their plans are typically more successful and profitable,” former vice president Al Gore claims in a June 2020 Wall Street Journal op-ed.7 At the same time, the emphasis has shifted from divestment to stewardship, where groups of activist share- holders work to force companies to divest themselves of activities deemed immoral or antisocial. Whereas divesting stock risks exposing the underperformance of divesting shareholders and the possibility of their being in breach of their fiduciary duties, the stewardship mode of divestment forces all investors to bear the financial consequences of business line divestment in proportion to their shareholding.

In contrast to the “doing well by doing good” sales patter of today’s ESG advocates, ethical investors in the past accepted that avoiding “sin stocks,” such as tobacco and defense contractors, involved making a financial sacrifice for the sake of one’s moral principles. Like its forebear, ESG introduces a constraint, but one that supposedly boosts risk-adjusted returns. For example, the S&P 500 ESG index excludes some 200 companies, among them Berkshire Hathaway, Johnson & Johnson, and S&P’s rival Moody’s. Similarly, the MSCI KLD 400 Social Index excludes securities of companies involved in nuclear power, military weapons, and genetically modified organisms.8 There is no financial or investment rationale for the systematic exclusion of such businesses.

Modern investment theory emphasizes the importance of portfolio diversification to maximize risk-ad- justed returns. In principle, an unconstrained investor can replicate exactly the same portfolio as an ESG-constrained investor, whereas the latter is barred from the range of investment choices open to the unconstrained investor. As a result, the unconstrained investor will always possess an advantage, as Pro- fessors Bradford Cornell and Aswath Damodaran explain in their March 2020 paper “Valuing ESG: Doing Good or Sounding Good?”:

[T]he notion that adding an ESG constraint to investing increases expected returns is counter intuitive. After all, a constrained optimum can, at best, match an uncon- strained one, and most of the time, the constraint will create a cost.9


Advocates of ESG delivering superior investment performance (“risk/return ESG”) must assume that the stock market doesn’t behave as modern finance theory suggests it will. It is not sufficient merely to assert, as Al Gore does, that companies incorporating ESG considerations into their business are more profitable. Proponents of risk/return ESG conflate “evidence of a relationship between an ESG factor and firm performance with evidence that such a relationship, if it exists, can be exploited by an investor for profit,” argue law professors Schanzenbach and Sitkoff in a 2020 paper.10

For the risk/return ESG hypothesis to hold, it is necessary that the stock market systematically fails to fully incorporate information on this superior performance into stock prices. Once the market has fully incorporated such information, the outperformance of ESG-favored stocks (by generating above-average risk-adjusted returns) will cease. As the market incorporates relevant ESG data into stock prices, the discount rate (the return required by investors) for highly rated ESG companies will fall, and that for low-rated ones will rise, leading to rising stock prices of ESG companies and falling prices of low-rated ESG stocks. Cornell and Damodaran explain the process:

[D]uring the adjustment period the highly rated ESG stocks will outperform the low ESG stocks, but that is a one-time adjustment effect. Once prices reach equilibrium, the value of high ESG stocks will be greater and the expected returns they offer will be less. In equilibrium, highly rated ESG stocks will have greater values, but investors will have to be satisfied with lower expected returns.11

After this one-off adjustment, the higher discount rate of low-rated ESG stocks implies that they offer higher returns, while the higher ratings of ESG-favored stocks mean that they offer investors lower expected returns. In the words of Nobel laureate Eugene Fama, widely recognized as the father of the efficient market hypothesis: lower costs of capital for E&S [environmental and social] accredited firms mean that for E&S investors, virtue is its own reward since investors get lower expected returns from the shares of virtuous firms.12

In his March 2020 book Grow the Pie, Alex Edmans, professor of finance at London Business School, takes to task ESG claims that outperformance of ESG strategies is beyond doubt. “Such a claim is unfor- tunately not true, but often accepted uncritically given confirmation bias,” he writes.13 A 2008 analysis shows that SRI funds in the US, the UK, and several European and Asian countries generally don’t beat the market. In a separate meta-analysis, the same researchers found that SRI funds perform similarly to non-SRI funds in the US and the UK but underperform in Europe and Asia.14

Is ESG a vaccine for Covid?

The popularity of ESG investment strategies soared during the Covid-induced market sell-off in the
first quarter of 2020. Morningstar dubbed ESG an equity vaccine. “Stocks, too, now need this improved immunity,” it argued.15 Seven out of 10 sustainable-equity funds finished in the top halves of their Morningstar Categories, and 24 of 26 ESG-tilted index funds outperformed their closest conventional counterparts, Morningstar reported. “More stable, more secure, well-managed companies with solid en- vironmental, social and governance (ESG) practices have generally responded well to the crisis,” claimed John Streur, CEO of the ESG-focused investment manager Calvert.16

Elizabeth Demers, financial accounting professor at the University of Waterloo, tested this proposition with three colleagues in an August 2020 paper, “ESG Didn’t Immunize Stocks Against the COVID-19 Market Crash.” Importantly, their analysis controls for the full array of other determinants of expected stock market performance, such as accounting-based measures of financial performance, firm age and market-share industry affiliation, and market-based variables that are known determinants of returns. Their conclusion:

[O]ur results provide robust evidence that ESG is not significantly associated with stock market performance during the first quarter of 2020 once the full array of other expected returns have been controlled for.17

Instead, their results show that Covid-crisis returns are associated with firms’ leverage and cash posi- tions, as well as with industry-sector indicators and market-based measures of risk. Three groups of vari- ables offer almost all the model’s explanatory power for returns: market-based risk variables, industry effects, and accounting-based measures such as liquidity and leverage. “ESG is responsible for a meager 1% of the total explained variation.”18 It gets worse. During the market’s Covid recovery period (sec- ond-quarter 2020), the finding is even starker: ESG scores are significantly negatively associated with returns during the market’s recovery phase.19

Sin stocks and the falsification of ESG

According to the risk/return ESG investment theory, the negative reputation of poorly rated ESG compa- nies—the risk of litigation, ever-tightening government regulation, and so on—should lead these stocks to underperform the stock market. The data, however, decisively disprove this component of the risk/re- turn ESG investment thesis. “Another inconvenient truth is the outperformance of ‘sin’ industries,” writes Edmans in Grow The Pie: How Great Companies Deliver Both Profit and Purpose.20

In their 2009 paper, “The Price of Sin: The Effects of Social Norms on Markets,” Professors Harrison Hong and Marcin Kacperczyk found that “sin” stocks—alcohol, tobacco, and gaming—had an 18% lower institutional-ownership ratio than stock of their comparable companies during 1980–2006.21 The relative neglect of sin stocks by institutional investors means that the prices of those stocks are depressed relative to their fundamental values. In turn, this means sin stocks should have higher expected returns than otherwise comparable stocks. Sin stocks also tend to benefit from very conservative accounting be- cause their industries come under intense regulatory scrutiny, meaning that their reported earnings are at lower risk of being subsequently restated or hiding nasty surprises.22

“In the short run, the market is a voting machine but in the long run, it is a weighing machine,” said Benjamin Graham, the father of value investing. Institutional underweighting of sin stocks caused by noneconomic factors interposes a price signal implying greater risk (reflected in depressed valuations and, by extension, higher cost of capital) than warranted by business fundamentals—Graham’s voting machine depressing the stock price. As unwarranted risk fails to crystallize and cash flows materialize, the stock price appreciates, as Graham’s weighing machine takes over.

Analyzing data from 1965 to 2006 using conservative cross-sectional regression analysis, Hong and Kacperczyk found that US sin stocks outperformed their comparables by 29 basis points a month. They also compared valuation ratios of sin stocks to those of other stocks and found that they are, on average, 15%–20% lower than those of other companies. Using a Gordon growth-dividend model, these valuation ratios imply excess returns of about 2% a year, which is not statistically different from the 29 basis points derived from the cross-sectional analysis. Extending their analysis to Canada and six European markets with similar attitudes toward sin stocks, sin stocks outperformed other stocks by about 2.5% a year, simi- lar to estimates for the US.23

These findings on US markets hold even when excluding tobacco stocks. Tobacco smoking is subject to stringent controls and is heavily taxed. As a result, tobacco consumption has declined. At the same time, tobacco company profits rose. For example, the number of cigarettes smoked in the UK fell by 12.2% in the five years to 2011. Over the same period, the profit margins of the UK market leader, Imperial Tobac- co, rose from 62% to 67%.

“Every time the government increases tobacco duty, tobacco companies put their prices up further,” an article in the Financial Times noted. “One tobacco analyst, who asked not to be named, described the re- lationship between the tobacco companies and the government as ‘a cosy conspiracy.’ ”24 Since 1998, the shares of UK market leader Imperial Brands (formerly Imperial Tobacco) rose more than fivefold against a 5% rise in the FTSE 100 index.

Savvy investors like nothing better than an exogenous, noninvestment constraint on other players in the market. Perhaps the most famous is Black Wednesday (September 16, 1992), when George Soros made about $1 billion by shorting sterling when, for political reasons, the Bank of England had to buy its overval- ued currency, thanks to Britain’s membership of the European Exchange Rate Mechanism. Similarly, when ethical investors shun sin stocks, it makes them cheaper for other investors to buy and make more money.

In their 2020 paper, Schanzenbach and Sitkoff suggest that the lower ratings effect of non-ESG stocks could create a rationale for a contrarian-ESG investment strategy, as a trustee might reasonably conclude that the market has overreacted to negative ESG factors for a tobacco or oil company, depressing the firm’s stock price, thereby giving rise to a profit opportunity.25

A 2003 study finds that, from the perspective of an investor who seeks to create an optimal portfolio from mutual funds, limiting oneself to funds that include social objectives can be very costly.26 The man- agers of the teachers’ pension fund TIAA ascribed its underperformance in 2017 to following ESG crite- ria, which meant that the fund did not invest in a number of stocks and bonds, “the net effect [of which] was that the Account underperformed its benchmark.”27 CalPERS decided in 2000 to divest from tobac- co, concluding that this would cost roughly $3 billion in returns.28 CalPERS, which funds the pensions of 1.6 million California public employees, had unfunded liabilities of more than $138.9 billion in 2019.29

The importance of materiality

As noted in Part I, ESG bundles attributes that are scored and weighted differently by different ESG rat- ers. Neither do ESG ratings differentiate between ESG factors that are material to the individual business and those that are not.

In a November 2016 paper (pre-print March 2015), Professors Mozaffar Khan and George Serafeim and Aaron Yoon of Harvard Business School aggregated performance of 2,396 enterprises across 51 stakeholder dimensions scored by KLD (now part of MSCI) over 21 years. Those with high sustainability scores beat the market only by what the authors describe as a statistically insignificant 1.5% a year.

Firms that scored high on material issues to their business (derived from industry-specific guidance from the Sustainability Accounting Standards Board [SASB]) and low on immaterial ones beat the market
by a statistically significant 4.83% a year, but those with high investment in immaterial issues and low investment in material ones lagged the market by 0.38% a year—a difference of 5.20%.30 ESG per- formance measures that take into account materiality are more likely to clarify “the relation between sustainability and a firm’s financial performance,” they conclude.31

Edmans pioneered research into a highly material aspect of “S”: employee—in his terminology, col- league—satisfaction. Examining the stock performance of the 100 Best Companies to Work for in America from 1984 to 2011, Edmans found that they delivered stock returns that beat their peers by an average of 2.3%–3.8% a year, or 89%–184% cumulatively.

The Parnassus Endeavor Fund, started in 2007 with the sole criterion of employee satisfaction, has delivered annual returns of 12.2% a year, compared with 8.5% for the S&P 500. “Treating colleagues as partners in the enterprise, rather than as a resource to be exploited or a cost to be minimized, benefits both workers and Wall Street,” Edmans concludes.32

1  BlackRock, “Larry Fink’s 2019 Letter to CEOs: Profit & Purpose,”

2  Kate Allen, “Lies, Damned Lies and ESG Rating Methodologies,”, Dec. 6, 2018, Lies--damned-lies-and-ESG-rating-methodologies.

3  Florian Berg, Julian F. Kölbel, and Roberto Rigobon, “Aggregate Confusion: The Divergence of ESG Ratings,” May 17, 2020, sol3/papers.cfm?abstract_id=3438533.

4  Sarah O’Connor, “Sustainable Funds Should Vet Their Investments Better,” Financial Times, Aug. 5, 2020, a54c-4cec-9af6-ada8b4955e20.

5  Max M. Schanzenbach and Robert H. Sitkoff, “Reconciling Fiduciary Duty and Social Conscience: The Law and Economics of ESG Investing by a Trustee,” Stanford Law Review 72 (Feb. 2020): 393.

6  Siew Hong Teoh, Ivo Welch, and C. Paul Wazzan, “The Effect of Socially Activist Investment Policies on the Financial Markets: Evidence from the South African Boycott,” Journal of Business 72, no. 1 (1999): 79, 83.

7  Al Gore and David Blood, “Capitalism After the Coronavirus,” Wall Street Journal, June 29, 2020.

8  Bernard S. Sharfman, “Re: Financial Factors in Selecting Plan Investments Proposed Regulation,” July 22, 2020,

files/EBSA/laws-and-regulations/rules-and-regulations/public-comments/1210-AB95/00147.pdf, 7.

9  Bradford Cornell and Aswath Damodaran, “Valuing ESG: Doing Good or Sounding Good?” (Mar. 20, 2020), 19.

10  Schanzenbach and Sitkoff, “Reconciling Fiduciary Duty and Social Conscience,” 390.

11  Cornell and Damodaran, “Valuing ESG,” 13.

12  Eugene F. Fama, “Market Forces Already Address ESG Issues and the Issues Raised by Stakeholder Capitalism,” posted on Harvard Law School Forum on Corporate Governance, Oct. 9, 2020, issues-raised-by-stakeholder-capitalism.

13 Alex Edmans, Grow the Pie: How Great Companies Deliver Both Purpose and Profit (Cambridge: Cambridge University Press, 2020), 92.

14 The two papers cited by Edmans are Luc Renneboog, Jenke Ter Horst, and Chendi Zhang, “The Price of Ethics and Stakeholder Governance: The Performance of Socially Responsible Mutual Funds,” Journal of Corporate Finance 14 (2008): 302–22; and “Socially Responsible Investments: Institutional Aspects, Performance, and Investor Behaviour,” Journal of Banking and Finance 32 (2008): 1723–42.

15 Andrew Willis, “ESG as an Equity Vaccine,”, Apr. 24, 2020,

16 Ruth Saldanha, “Why ESG Matters in Downturns,”, Apr. 21, 2020, in-downturns.aspx.

17 Elizabeth Demers et al., “ESG Didn’t Immunize Stocks Against the COVID-19 Market Crash,” Aug. 27, 2020, cfm?abstract_id=3675920, 3.

18 Ibid., 4.

19 Ibid.

20 Edmans, Grow the Pie, 94.

21 Harrison Hong and Marcin Kacperczyk, “The Price of Sin: The Effects of Social Norms on Markets,” Journal of Financial Economics 93 (2009): 16.

22 Ibid., 17.

23 Ibid.

24 Christopher Thompson, “Tobacco Tax Smokescreen Evaporates,” Financial Times, Dec. 7, 2012.

25 Schanzenbach and Sitkoff, “Reconciling Fiduciary Duty and Social Conscience,” 444.

26 C. Geczy, R. Stambaugh, and D. Levin, “Investing in Socially Responsible Mutual Funds,” unpublished working paper, University of Pennsylvania, Wharton, 2003, cited in Hong and Kacperczyk, “The Price of Sin,” 16.

27 Cornell and Damodaran, “Valuing ESG,” 19.

28 Schanzenbach and Sitkoff, “Reconciling Fiduciary Duty and Social Conscience,” 430.

29 Public Policy Institute of California, “Public Pensions in California,” Mar. 2019, text=California’s%20largest%20public%20pensions%20have,current%20value%20of%20their%20assets.

30 Mozaffar Khan, George Serafeim, and Aaron Yoon, “Corporate Sustainability: First Evidence on Materiality,” working paper 15-073 (2015), table 7. 31 Ibid., 5.
32 Edmans, Grow the Pie, 85.



Rupert Darwall is a senior fellow of the RealClearFoundation, researching such issues as energy and environmental policy and corporate governance. He previously worked as an investment analyst and in corporate finance, as well as serving as a special advisor to the UK’s Chancellor of the Exchequer. The author of two books—Green Tyranny and The Age of Global Warming—and numerous think-tank reports, Darwall has also written for the Wall Street Journal, The Hill, and Daily Telegraph, among others.

Darwall can be contacted at [email protected]

Send this article to a friend: