As numerous posts on our blog demonstrate, energy and climate change are issues that we have analyzed in depth. Our senior advisor, Professor Cornell, will be teaching a new course on Energy, Climate Change and Finance at both the Anderson School at UCLA and the Rady School at UCSD in the upcoming academic year. You might guess, therefore, that we are aggressive ESG investors with regard to energy and climate, but that conclusion is wrong. For the most part, we do not believe it is wise to place political or societal constraints on our investments, including those related to ESG, for a number of reasons.
The first reason is simple. Our primary objective is to provide the best possible, risk adjusted, investment performance for our clients. Any constraints placed on the opportunity set of securities we consider makes optimal diversification more difficult and degrades performance. It is important to recognize than any constraint on portfolio choice will at best have no impact on performance. An investor without a constraint can always choose to match the portfolio of a constrained investor if that is thought to be optimal, but the reverse is not true. In this respect we have read a variety of recent articles noting that ESG portfolios have outperformed in recent years. This is not surprising. Gold stocks do well when gold prices rise. ESG stocks do well when interest in them grows, performance is good, and fund flows are positive. But this does not mean that such performance can be expected to continue. To the degree that we can find attractively priced ESG investments, we will be delighted to take them. But to impose the constraint that we will always overweight ESG stocks is farther than we are willing to go.
The second reason is that it is far from clear what an environmentally conscious investment policy should look like. A potential policy, recently adopted by the University of California, would avoid companies that make fossil fuels. But making fossil fuels is not the problem, burning them is. Because air travel is the most profligate use of fossil fuels should we avoid investment in airlines? What about companies that make cars that run on fossil fuels? Or manufacturers that burn fossil fuels to produce products like steel? Or firms that make equipment for oil and gas exploration? Where does it stop? In our view, the best place is not to start.
The third reason is that we believe, despite the current disfunction in Washington, that the best way to deal with climate change is through public policy – starting with a carbon tax. As Nobel Prize winner William Nordhaus says, climate change is the mother of all externalities. We believe the way to deal with externalities is through public policies that result from open and transparent debate. We are not in favor of having investments firms and corporations make such crucial decision without being in the spotlight of public debate and without having to answer to all citizens via public elections.
For all these reasons, we plan to place few ESG restrictions on the investments we hold for our clients. In the public arena, we will push for environmental policies, like the aforementioned carbon tax, that we believe are critical for addressing the climate issue, but as investors we will focus on producing the best risk adjusted return for our clients.