Sinner or Saint - ESG Investing vs. Vice Investing

Episode Summary

Executive Summary: Patrick Boyle discusses the rise of ESG (Environmental, Social, Governance) investing versus 'SIN stocks' (vice investing) in finance. He contrasts two theories of ethical investing: one that improves the world by raising capital costs for unethical firms (yielding lower returns) and another that profits from long-term societal shifts (yielding higher returns). The episode examines performance data, noting that SIN stocks have historically outperformed, while ESG funds recently benefit from tech-weighting. Boyle explores cultural differences, investor demographics, and risks associated with vice investing.

Main Topics: ESG Investing Growth and Scale (Priority: 5/5): ESG funds attracted $350 billion over two years, nearly double other stock funds combined. ESG bonds surged, with 17% of bonds issued in one month labeled as sustainable. Saudi Arabia's PIF considered green bonds despite ethical concerns. SIN Stocks Definition and Evolution (Priority: 4/5): Historical SIN stocks include weapons, alcohol, gambling, and tobacco. Now expanding to energy (polluters), animal products (vegan view), and even tech (YouTube as 'slot machine'). Cultural differences in accepting behaviors (e.g., debt, interest) shape different SIN stock categories. Theories of ESG Impact on World and Returns (Priority: 5/5): First theory: Raising cost of capital for bad firms improves world but lowers returns for ESG investors (green bonds yield ~2 basis points less). Second theory: ESG profiting from long-term trends (clean energy, regulation) without directly causing change implies potential outperformance. Historical Performance of SIN vs ESG (Priority: 4/5): Fabozzi (2008) found SIN stocks generated excess returns in all 21 countries over 37 years, with double-digit excess in 16 countries. Hong and Kacperczyk found hedge funds benefit while pensions lose. Vice Fund (VICEX) outperformed market on risk-adjusted basis since 2002, but lagged recently due to COVID impact on aerospace/casinos. Demographics and Investor Behavior (Priority: 3/5): Boomers moved from <0.5% to >5% of assets in ethical funds over 5 years. Millennials have ~4% in ethical funds, with rest speculated to be in Bitcoin (criticized for high carbon footprint). Reasons for SIN Stock Outperformance (Priority: 4/5): Possible causes: systematically cheaper due to investor avoidance; less competition due to capital raising challenges; compensation for regulatory, tax, and legal risks. Higher returns may simply be risk premiums. Critique of ESG Composition and Bias (Priority: 3/5): Many ESG funds/indices are heavily weighted in tech stocks (Facebook, Apple, Amazon) and exclude energy. This weighting significantly contributed to their higher recent returns, raising questions about whether tech is truly 'more ethical' than excluded sectors.

Key Arguments: The two dominant theories of ESG investing are contradictory: one claims it lowers returns to improve the world, the other claims it exploits future trends for higher returns. Raising cost of capital for SIN stocks implies ethical investors will earn lower returns, a fact not advertised by ESG fund marketers. SIN stocks have historically outperformed due to being undervalued (avoided by norm-constrained investors) and facing less competition. Recent ESG outperformance is largely due to tech stock overweighting, not necessarily ethical screening. Higher SIN stock returns may compensate for regulatory, tax, and legal risks inherent in those industries. Different definitions of 'sin' across cultures and time periods complicate universal ESG standards. Less norm-constrained investors (hedge funds) capture SIN stock excess returns, while pension plans underperform.

Data Points: ESG fund inflows: $350 billion - Over last two years, nearly twice the rest of the stock fund universe combined. ESG bond issuance increase: 17% of bonds issued in recent month - More ESG bonds in first half of 2021 than full year 2020, per Bank of America. Green bond yield difference: ~2 basis points less - Green bonds yield lower than comparable non-green corporate bonds. Boomer ethical fund allocation shift: <0.5% to >5% - Over last five years, boomers dramatically increased ethical fund holdings. Millennial ethical fund allocation: ~4% - Millennials have about 4% in ethical funds, rest in Bitcoin according to Boyle's speculation. SIN stock excess returns (Fabozzi study): Double-digit in 16 of 21 countries - 37 years of data across 21 countries show consistent excess returns for SIN stocks. Vice fund inception year: 2002 - VICEX fund has mostly outperformed market on risk-adjusted basis since inception.

Pivotal Quotes: "The logic of raising SIN stocks' cost of capital implies that an ethical investor in the long run will get lower returns than a SIN stock investor." — Patrick Boyle: Explaining the first theory of ESG impact—improving the world means accepting lower returns. "It profits when governments move faster than expected to regulate certain industries, but the investments themselves do nothing to bring about these changes." — Patrick Boyle: Critiquing the second ESG theory, noting the disconnect between investment and actual world improvement. "Sin stocks might just be systematically cheaper than their fundamentals would suggest, simply because certain types of investors avoid them." — Patrick Boyle: Explaining one reason for SIN stock outperformance—valuation discount due to avoidance.

Implications: Investors must clarify whether ESG goals are ethical (lower returns) or profit-oriented (riding trends). The historical outperformance of SIN stocks suggests that excluding them may incur an opportunity cost. ESG's recent outperformance may be fleeting if tech stocks falter. Understanding the risk/reward trade-off and one's own investment philosophy is crucial.