100: Versus “The Gathering Darkness” Part 9 – What About Social Responsibility (ESG)?

0:00:00 – Jonathan DeYoe
My favorite characteristic of rational profit-taking businesses is their absolute refusal to lose money our money for any longer than is necessary. And then the corollary, my second favorite characteristic their total embrace of innovation. We also learned why all retirement income investors should love owning shares of the great companies of the US and the world. A couple weeks ago, we talked about the summary objection to owning equities, the objection that says this time is different, and we also learned about it. It’s antidote that this, too, shall pass.

0:00:36 – Speaker 2
Do you think money takes up more life space than it should? On this show, we discuss with and share stories from artists, authors, entrepreneurs and advisors about how they mindfully minimize the time and energy spent thinking about money. Join your host, jonathan Diyo, and learn how to put money in its place and get more out of life.

0:01:09 – Jonathan DeYoe
Complete the step-by-step case for owning publicly traded shares in the great companies of the US and the world. Whether you use words like stocks or equities instead of great businesses, it’s important to how we feel about owning them. We learned that the importance of investors for having an adult memory can’t be overstated. We learned that my favorite characteristic of rational profit-taking businesses is their absolute refusal to lose money our money for any longer than is necessary. And then the corollary, my second favorite characteristic their total embrace of innovation. We also learned why all retirement income investors should love owning shares of the great companies of the US and the world. A couple weeks ago, we talked about the summary objection to owning equities, the objection that says this time is different, and we also learned about it. It’s antidote that this, too, shall pass. And we saw how committing to owning the great businesses of the US and the world could improve results for lifetime asset accumulation, retirement income production and legacy creation. And finally, last week we defined exactly what companies we mean when we say the great companies of the US and the world. Hopefully, you know that this introductory overview can’t do any of the individual episodes justice, so I hope you’re going to go back and listen to each of them. If they can each help you understand, if not love, owning shares of the great companies of the US and the world and thereby build greater wealth for you and your family, I will feel as if my job is done.

Today we want to ask and answer the question of socially responsible investing, sri or ESG investing, especially the EBIT for the environment. To begin, let’s talk about the portfolio design process. When an advisor works with clients, or when I build a portfolio for a family’s cherished lifetime objectives, there is an order of operations at work. The most important decisions, those that have the greatest long-term impact on a family’s lifetime financial outcomes, come first. Then there are other decisions that follow. Security selection is at the end of the order.

The choice of SRI and ESG investments is the final stage of the security selection process. There’s a whole lot to do before we even consider whether or not to invest with SRI, esg and mind. We start by trying to understand what’s important to the family. What are their values? Knowing their values leads to the goals and priorities. We align resources with goals and priorities in the form of a plan. The plan and some simple math will produce an appropriate asset allocation. Only then do we start thinking about the specific investment tools that make sense for any family or any investor. The order of operations for portfolio construction is this Values, goals, plan, asset allocation, tool selection. Tool selection comes fifth. Tool selection is where social responsibility can be easily implemented. However, this is where it can get a little bit tricky because, for one, definitions of social responsibility will differ significantly and, two, the tools to employ social responsibility are limited but improving. So there are many definitions of SRI ESG.

I have a client who, upon our first engagement in the early 2000s, was more concerned about social responsibility than she was about her own and her family’s goals. Investing for her was more about doing as little harm as possible than it was about return. She wasn’t among today’s anti-capitalists, but she was close. She had a lot of money so she could make this decision without sacrificing current or future lifestyle. If, given the chance, she would have excluded everything.

I understand the concern, but this makes it very hard to diversify and, as you know, I believe in the great companies and I love the idea that they’re there to fulfill our wants and needs. That they do it for a profit does not bother me at all. I also have many clients for whom social responsibility means LGBTQ plus rights, and many who wish to exclude companies who manufacture weapons and many who are more focused on the environmental sustainability. Even when there is a general agreement on the issue, as in sustainability, how that gets implemented is open for debate. Some believe we should own shares in the offending companies and agitate. Others believe we should simply not own shares of the more irresponsible companies. I work with a few families whose idea of social responsibility is to eliminate any tobacco-related companies. Finally, I’ve worked with more than one person happy to simply exclude Hellebur. Yep, I said it there can be no one-size-fits-all solution because our definitions of social responsibility are all over the map.

And then there’s this question of the available investment tools. There are over 10,000 mutual funds and exchange traded funds ETFs in the US alone. Of these, about 5% a little more than 500, are ESG SRI tools. This number is itself up about three times in the last five years, which is a vast improvement, and where the ESG SRI portfolio tools used to add an additional 1% in cost and now only adds a fraction of that additional cost, especially with the advent of passive social indices and ETFs. Today, the ability to implement a basic social responsible portfolio is easier than ever.

For most people, the best way to do so is by replacing their traditional investment tools with those indices that we all love with ESG alternatives from the same company. So if you like ETFs and you’re a fan of iShares, it looks something like this you would take your iShares core S&P 500 ETF the symbol is IVV, and that would become the iShares ESG screened S&P 500 ETF, symbol XVV. And in the mid cap space you would say you take your iShares core S&P mid cap ETF, symbol IJH, and that would become the iShares ESG screened S&P mid cap ETF symbol XJH. And in the small cap space you would take the iShares core S&P small cap ETF symbol IJR and replace that with the iShares ESG screened S&P small cap ETF symbol XJR. The same thing can be done at Fidelity Vanguard State Street Dimensional across the board.

If you stick with the major index providers and the major investment product manufacturers that we talked about last week, you’ll be able to find a socially responsible way to build a simple, acid-allocated, broadly diversified and rebalanceable portfolio. So long as you follow the order of operation, steps one through four, and you remain committed to broad diversification, it hardly matters in the long term whether or how you choose to express social responsibility in your portfolio. Very good arguments in terms of performance can be made both for and against a socially responsible portfolio, but no one knows what the future holds. Maybe excluding oil in the long term will reduce your portfolio’s total returns, or maybe there will ultimately be a reckoning of the true cost of resource extractable companies and those companies will end up paying the social cost of their extraction. In the present, we can’t know.

Those of us who choose the SRI ESG path should stick with the broad index and have exposure to as many companies as can fit within our ideas of social responsibility. As an example, the choice of whether you own the DFA US Equity Core Portfolio symbol DFEOX or the DFA US Sustainable Core Portfolio symbol DFSIX identical portfolios except for the latter adds a tilt towards more sustainable companies. The decision hardly matters at all. This graph is a comparison of the two funds since the inception of the sustainable option on March 12, 2008. Dfeox currently pays a 1.36% dividend, while DFSIX pays a very similar 1.24% dividend. You can see that between 2014 and 2019, it appeared that the non-sustainable option had the upper hand, but during the pandemic they switched places and now the sustainable option is leading by a slight market.

Looking forward five years or 10 years, it’s impossible to know whether investing sustainably will enhance performance or detract from it. There are no facts about the future. Whether or not to be socially responsible is a deeply personal question and in terms of portfolio design, it is merely a tool selection issue. It barely moves the needle of investor outcomes which, as someone focused on improving investor outcomes, is why you don’t see me discuss this very much. The real problem with SRI ESG in general it is much more a marketing benefit for advisors and a pricing benefit for product makers than it is an outcome benefit for clients. I know many advisors who make social responsibility and ESG investing their core message and every one of them would tell you that among their reasons that it was a marketing differentiator, it attracted clients. The SRI ESG world is growing, but it is still incredibly small compared to traditional investing universe.

Choice creates competition and reduces prices, but fewer choices means higher costs. The reason that product manufacturers have increased their SRI ESG product offering so much in the last five years is because of consumer demand. When the consumer wants a thing built, we build the thing. This is kind of a wonderful future of capitalism. But that’s a digression. The building of the thing has nothing to do with whether the research on social responsibility was any good, or whether the data on underlying companies is high quality, or even whether the thing being built produces the outcome that the consumer thought it would produce. These are all secondary to meeting consumer demand.

So does investing with responsibility in mind push companies to be more responsible? How effective is the mechanism? Is there a long term cost to the investor? How badly does the cost affect the investors involved? Is the cost worth the benefit to the issues dear to the same investor? Is the juice worth the squeeze? Because demand is so high and the supply of SRI ESG options is still only 5% of the total number of choices, we find that the SRI ESG offerings are more expensive to the client, regardless of how they perform, relative to their non-responsible counterparts.

The largest performance differentiator between well-managed index portfolios is cost of the particular index tool. If an S&P 1500 portfolio has a higher cost associated with it, it will produce a lower return for the end user. Whether it’s responsible doesn’t predictably move the long-term needle. The cost of the tool has a larger known effect on the long-term performance outcome to a client. Then does the moniker responsible. So how does it work? What happens when the consumer wants to express their values in their portfolios? First the index provider creates a screened index with a little higher price and sells the use of that index to the product manufacturers. Then the product manufacturer builds a screened index portfolio with a higher price for the consumer to use. The result is a new index product with a tilt towards SRI ESG, which is among the higher priced options for access to the same index. The index provider takes a higher fee. The product manufacturer takes a higher fee. The consumer receives a lower return. The lower return while relying on screened index portfolios becomes a much lower return once we start using did management to build the SRI ESG portfolios for clients, and this was the only option just 10 years ago. It’s getting better.

But as a financial writer focused on family outcomes, I have a problem with the cost. Obviously, every investor can choose whether the cost is worth it to them. I’m never going to stand in the way when somebody says Jonathan, I need this to be socially responsible. But the additional cost is why I don’t speak about SRI ESG more often. Mindful Money has a growing subscriber base. We’ve got over 2000 readers. The Mindful Money Weekly started out as a weekly client newsletter about 20 years ago. Today, less than 10% of my readers are clients. That means I don’t know the financial situation of over 90% of my readers.

Given the above, the deeply personal nature and the increased expense of the SRI ESG portfolio, it would be, I think, irresponsible of me to push SRI ESG broadly. Many people have expressed disappointment that I don’t speak more often about SRI ESG, that I don’t push it for clients. For a small number of folks, the disappointment is sort of akin to moral outrage, but they have not seen what I have seen and they do not know what I know. I know people who have run out of money. They would tell you that running out of money is worse than death. I would not wish this on my worst enemies For a world on the cusp of a retirement income crisis where many more people are going to run out of money before they run out of life. Most people should be using the pure index and seeking to maximize their own total return. I do not view this as their being selfish. I view this as their taking responsibility for a very real, very difficult and very immediate problem. They’re doing their best and I don’t want them to feel guilty for doing their best. This is why I write what I write.

In the grand scheme, the lifetime success or failure in personal, financial terms of a family can be reduced to three issues how much we earn, how much of what we earn we invest and how much of what we invest we commit to permanent ownership of the great businesses of the US and the world. I can’t do much to boost someone’s earnings other than provide some basic job counseling and maybe suggesting that solo entrepreneurs increase their fees. On a one-to-one basis, I can stimulate saving and investing through some simple values, discovery and planning. The biggest difference I can make in the outcome of real families is to offer, first, repeated reminders of the importance of their permanent commitment to the ownership of great businesses and, second, long-term perspective and counseling whenever that commitment is tested. For the last eight, nine weeks, throughout the Gathering Darkness and Versus the Gathering Darkness series, I’ve been focusing on the major issues, fears and mistaken beliefs that keep people from owning great businesses. This is where I can make the greatest difference. This is where most of my writing will forever be focused.

Sri ESG investing has gotten a lot better in the last decade and it continues to improve. The information about companies is cleaner, the data accessible to the index providers is more consistent and higher quality. There’s more competition among providers than ever and prices are coming down. We offer SRI ESG portfolios and we have lots of clients who use them. Personally, I invest a portion of my publicly traded equity portfolio in ESG funds and all of my private equity portfolio is bent towards ESG and its bigger brother, impact Investing. I have an emphasis on sustainability. I believe in it, but I also believe it is a second order concern for most families who are struggling or who will struggle to make ends meet in retirement or who will never be able to retire. Some would call ESG investing a responsibility, and maybe in a way, it is.

I look at it a little differently. The opportunity to invest SRI ESG in mind is a privilege. I’m proud to do it. I’m proud to offer it as a choice for people who can offer, who can afford to make that choice. It isn’t right for everyone. Thank you for coming along with me on this journey. I am an investor. I am absolutely committed to owning shares in the great companies of the US and the world in the most broadly diversified fashion possibly. I own my shares in these great businesses because owning them is the only way I can rely on their absolute refusal to lose money and engage their total commitment to innovation and enhanced productivity. I sincerely believe that my commitment to owning these shares is the reason my family enjoys the level of wealth we enjoy, and I believe the commitment is attainable by anyone willing to learn. There are no barriers to entry here other than a little disposable income and a whole lot of belief. I hope this has been helpful. I look forward to returning to our interviews next week.

0:19:07 – Speaker 2
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