The third quarter of 2021 saw geopolitical conflict and the return of various vaccine mandates as Delta variant cases surged. Below is a brief summary of what happened in financial markets between July 1 and September 30, 2021 followed by some perspective on markets in both the present and the future.
The strength of the first half of the year broke down in the third quarter with the S&P 500 up a modest 0.6% and the Russell 3000 giving back 0.1%. International markets were weaker yet with the MSCI EAFE finishing down 0.5% for the quarter and the MSCI Emerging Market Index dropping 8.1%. Style performance for Q3 was mixed with large growth stocks edging out large value stocks and small value stocks outperforming small growth stocks.
Despite the quarter’s weak performance, 2021 has been a resilient year of equity market performance with the S&P 500 up 13.3% year-to-date and the Russell 3000 up a stronger 15.0%. Internationally, equity markets have had a more measured year as the MSCI EAFE has added only 8.4% and the MSCI EM Index is down 1.3%. 2021 remains the year of the value stock with them sizably outperforming growth stocks across the cap spectrum.
In fixed income markets for the third quarter, the yield curve was mostly stable. Corporate spreads expanded during Q3 but tightened towards the end of September to finish only marginally wider. Domestic bonds battled to hold their ground after a weak start to the year with the core US government and credit market finishing just barely positive. High yield bonds added 0.8% this quarter, and global bonds lost 0.9%.
The flattish quarter for fixed income means the category is still in the red year-to-date with high yield being the only positive sector, adding 4.3%. This performance is on the back of the yield curve steepening throughout the year while spreads have tightened slightly.
Significant social and political events often shift or rejuvenate investors’ interest in various market themes. A prominent theme that has grown in intensity over the better part of two decades is ESG investing, strategies that consider how a company operates on an Environmental, Social and Governance level. Geopolitical conflict, mass environmental events like oil spills, and significant health crises are the common “rejuvenators” of ESG interest. During this recent rush towards these strategies, it is valuable to discuss ESG investing as well as its merits.
What is ESG investing?
Since the nascent years of financial markets, the creation of shareholder value has been the core pursuit of ethical C-suite executives. However, with time the world’s priorities have steadily changed. Many experts both inside and outside the financial industry have tried to measure the cost of a system solely focused on maximizing shareholder value. From this scrutiny arose the idea of socially responsible investing, most notably the ESG investing movement.
As indicated, ESG strategies focus on targeting companies that score highly in Environmental, Social and corporate Governance categories. The strategies invest heavily into companies that maximize these scores and avoid their low-scoring counterparts with the goal of increasing value for shareholders, people and the planet.
How exactly the strategies define high ESG scores often varies drastically. Some funds may focus on scores relative to industry. Perhaps they will invest in a fossil fuel company as long as the company goes above and beyond to offset its carbon foot print or enhance the sustainability of its production process. Other funds may avoid industries altogether, looking at ESG scores in a more absolute sense.
Even ESG scoring metrics themselves can sometimes vary. There are many factors that could be a proxy for sustainability and “goodness”. It can be difficult to unify these factors across all firms, funds or managers.
What do the proponents of ESG investing say?
Those who support ESG investing generally emphasize the basic premise that it is the “right” or “just” thing to do. Commercial enterprise is not the end-all be-all, and action should be taken to ensure the goal of profitability does not destroy the environment, the community or the lives of employees.
Supporters also emphasize the accountability the ESG movement creates for management teams. Pushing companies to disclose more about their practices should keep management honest and should allow for best-in-class processes to proliferate.
Another important conversation usually surrounds performance. While it was initially expected that ESG constraints would be cause for lower investment returns, there is now some evidence this may not be the case. In fact, a few studies have found that in some cases ESG strategies can outperform their unconstrained peers on a risk adjusted basis.
What do the opponents of ESG investing say?
While supporting the ESG investing theme can be the easy and “righteous” path, a few renowned financial professionals have taken serious issue with this ideology. Aswath Damodaran, NYU Stern Professor of Finance and fondly known “Dean of Valuation”, is one of these opponents.
While it’s only the most recent attack by Aswath in the history of ESG, his September 2021 blog post neatly lays out his argument against these strategies in four straightforward points. His claim is a bold one, emphasizing that ESG will not only “cost companies and investors money, while making the world worse off. It creates more harm than good for society.” Here are Damodaran’s four points:
1. Goodness is difficult to measure, and the task will not get easier.
2. Being “good” will add value to some companies, hurt others, and leave the rest unaffected.
3. The ESG sales pitch to investors is internally inconsistent and fundamentally incoherent.
4. Outsourcing your conscience is a salve, not a solution.
The investing merit of the ESG movement is a divisive topic with significant brainpower on both sides of the aisle. Further, as is true with many investment strategy debates, it may be difficult to ever declare an unequivocal winner of the argument as various definitions of “winning” are considered.
At WoodTrust, understanding our customers and managing their money consistent with their goals is paramount to our process. We pride ourselves on our connection with our clients, and we encourage constant dialogue between you and your Portfolio Manager to affirm your investment strategy’s alignment with your goals. As always, we thank you for your trust and look forward to our meetings with you in the near future.