From Ben and Rusty: With this note, we welcome Demonetized, a new guest contributor. No, that isn’t his real name. Rather atypically, this guest contributor is anonymous. To you, anyway – we know who he is. But even before we did, we were admirers of his approach and many shared point of views. We don’t and won’t always agree, but we’re very happy that he’s doing some pieces for us here. We think you will be, too.
In geekdom, the phrase “Kobayashi Maru” is synonymous with “no-win scenario.” It comes from a training exercise shown in the second Star Trek movie. The exercise presents a cadet with a crippled freighter, the Kobayashi Maru, broadcasting an SOS from restricted space. The cadet can either enter the restricted Neutral Zone and trigger an unwinnable space battle, or stand off and watch the crew of the Kobayashi Maru die. Like I said: a no-win situation. It’s intended as an ethical dilemma, and as a test of character and leadership ability. Toward the mid-point of Star Trek II, Captain Kirk is asked how he fared in the exercise.
Saavik: On the test, sir… will you tell me what you did? I would really like to know.
Dr. McCoy: Lieutenant, you are looking at the only Starfleet cadet who ever beat the no-win scenario.
Kirk: I reprogrammed the simulation so it was possible to rescue the ship.
David Marcus: He cheated.
Kirk: I changed the conditions of the test.Star Trek II: The Wrath of Khan (1982)
You know who’s struggling with the Kobayashi Maru these days? The long-only, discretionary active mutual fund manager. These firms are being squeezed by a proliferation of cheap beta; by increasingly demanding and fee-conscious financial advisory platforms; by their punitive tax treatment (compared to ETFs, anyway). You can either compete in the low-cost death spiral or you can exit the business.
Is there a way to beat this no-win scenario?
Well, like Kirk, you can try to change the conditions of the test. You can sell your product based on something other than fees and performance. You can sell product based on “values” and political identity. As we know, this is a particularly effective marketing strategy in a widening gyre. Consumer product companies have certainly figured it out. Nike has. So has Gillette. It’s a topic near and dear to Epsilon Theory.
In this note, I want to take a brief look at this strategy in the context of the investment business. That’s right, I want to talk about ESG.
ESG stands for Environmental, Social and Governance investing, and it’s all the rage these days. The idea is that your portfolio can (and should) reflect your values (assuming, of course, that your values are broadly in line with the Nudging State’s sustainability goals). In fact, many ESG proponents argue companies that score well on ESG measures perform better financially than those that score poorly.
The problem here is that the term “ESG,” much like “hedge fund,” is a cartoon. It’s so general as to be meaningless. There’s an incredibly broad spectrum of ESG strategies and scoring methodologies out there. Below is a stylized visual to illustrate:
This note isn’t meant to be broadly critical of ESG investing (though I think there’s a case to be made that much of the alleged performance benefit associated with ESG is just the Quality factor in disguise). I’m not dragging people who want to exercise their shareholder rights to influence corporate behavior, or people who want to fund specific projects related to education, housing, or renewable energy. I’m all for people exercising their shareholder rights, and putting capital at risk to fund projects they deem meaningful. To me, that’s economic freedom.
No, this note is meant to draw your attention to the Marketing BS end of the ESG Investing Continuum. This note is about ESG! the meme–ESG! as an asset manager’s solution to the Kobayashi Maru.
ESG! the meme isn’t about the performance benefits associated with ESG factors, or reducing the cost of capital for community lending cooperatives. ESG! the meme is about selling portfolios as virtue signaling devices, in an effort to stem the tide of outflows and fee compression.
Because here’s how ESG! is sold to financial advisors:
“The Millennials and The Women are going to inherit all the money when your Wealthy Male Clients die. The Millennials and The Women are the future of your business. The Millennials and The Women care about ESG! Here are surveys that show how much they care. And here is how to have the ESG!conversation with The Millennials and The Women. Once you have the ESG! conversation with The Millennials and The Women, you will be amazed at how much you can strengthen those relationships. Oh, and also here is some marketing collateral for all the new ESG! strategies we’ve either launched or acquired as the industry has consolidated.”
You might think I’m exaggerating here. I assure you I’m not. I’ve sat in several of these presentations over the last year. The script is remarkably similar across different firms. I’m merely stripping away the flowery language and storytelling a good salesperson will use to connect with the allocator or investor.
Now, this is an admittedly clever strategy. At least in theory, it moves the conversation away from fees and performance. Now we’re talking values. ‘Cause if performance is pretty decent, and the fees are reasonably competitive, wouldn’t you rather have a portfolio aligned with your values? Isn’t the alignment of your investment capital and your values worth it? Don’t you want to make a difference?
As a result, you see ESG! everywhere these days. Some days it seems as though it’s become a standard box for an asset manager to check. I’ve even seen it bolted onto municipal bond fund RFPs lately. (“Yeah, um, there’s not really an accepted definition of what ESG means for a municipal bond fund but we try and think about it, so sure, we do ESG analysis as part of our process.”)
Is it the worst thing in the world for people to invest this way?
No. You could do worse. Much worse.
But in keeping with the Epsilon Theory spirit, it’s important to view the proliferation of ESG products with Clear Eyes. Not only in terms of the efficacy of any given implementation, but in terms of how and why it’s being sold.
One man might call something ESG!
Another might call it “changing the conditions of the test.”