Sinner or Saint - ESG Investing vs. Vice Investing

Episode Summary

Executive Summary: Patrick Boyle examines the growth and claims of ESG investing alongside the performance of “sin” stocks. He questions whether avoiding controversial companies can meaningfully change their behavior, noting that this approach may raise their cost of capital and expected returns. A competing ESG pitch is that investors can profit from long-term social and regulatory shifts, though that does not mean their investments cause those shifts. Studies cited show historical excess returns for sin stocks, while risks and recent sector performance complicate comparisons.

Main Topics: Rapid growth and contested boundaries of ESG: ESG funds and labeled bonds are attracting substantial flows, but what counts as ethical varies across investors, cultures, and social norms. The episode uses Saudi Arabia’s planned green-bond issuance to illustrate possible tensions between environmental labels and broader governance concerns. How ethical investing is supposed to affect the world: One theory is that excluding unethical companies raises their cost of capital and encourages reform. Boyle argues that this influence requires substantial investment flows and that the theory implies higher expected returns for investors who buy the excluded securities. ESG as a bet on future winners: A second rationale is that ESG portfolios may benefit from clean energy, healthier lifestyles, and tighter regulation. Boyle distinguishes this from directly improving the world: the strategy may anticipate changes without causing them. Historical returns and potential sources of sin-stock premiums: Research cited in the episode found excess returns for sin stocks across multiple countries. Possible explanations include investor exclusions depressing valuations and limiting competition; returns may also compensate for regulatory, tax, and legal risks. Comparing the Vice Fund with ESG investments: The Vice Fund invests in tobacco, alcohol, gaming, and aerospace and defense. Boyle says it has mostly outperformed the broad market on a risk-adjusted basis since inception, but fared poorly more recently as pandemic conditions hurt areas such as casinos and aerospace. ESG funds’ technology exposure and energy exclusions also shaped comparisons. Who invests ethically and what qualifies as ethical: The episode challenges the assumption that millennials lead ethical investing: boomers’ allocation to ethical funds reportedly rose substantially, while millennials held a smaller share. It also asks whether large technology companies belong in ESG portfolios and what excluded industries signify.

Key Arguments: The commercial appeal of ESG is evident in strong fund inflows and rising issuance of socially responsible, sustainable, and green bonds, regardless of the investments’ moral merits. The claim that ESG exclusion reforms harmful businesses depends on investors raising those firms’ financing costs enough to influence decisions; the speaker questions whether even very large asset managers can point to companies put out of business through this mechanism. If exclusion raises sin stocks’ cost of capital, it also raises their expected returns for investors willing to hold them, implying a potential return trade-off for ethical investors. The alternative ESG argument is that investors can outperform by anticipating social and regulatory change and owning likely beneficiaries. This is a forecast about future winners, not evidence that investment choices themselves produce the change. Research cited by Boyle reports excess returns for sin stocks across 21 countries. These returns could reflect investor-driven undervaluation or reduced competition, but may also compensate investors for regulatory, tax, and litigation risks. Comparisons between ESG and vice strategies depend on portfolio composition and the period examined: technology-heavy ESG portfolios and energy exclusions affected returns, while pandemic-era conditions hurt some Vice Fund holdings.

Data Points: ESG fund inflows: About $350 billion over two years - The transcript says ESG funds attracted almost twice as much as the rest of the stock-fund universe combined over that period. ESG-related bond issuance: More in the first six months of 2021 than in all of 2020 - Indicates rapid growth in issuance, although the segment remained a small share of the overall bond market. Share of bonds issued with social-responsibility, sustainability, or green labels: More than 17% last month - Figure attributed in the episode to Bank of America. Boomers’ assets in ethical funds: Less than 0.5% to more than 5% over five years - The episode says boomers increased their allocation substantially during the period. Millennials’ assets in ethical funds: Around 4% - Presented as lower than boomers’ reported allocation; the speaker jokes about the rest being in Bitcoin. Green-bond yield difference: Around 2 basis points lower - The transcript compares green bonds with comparable non-green corporate bonds. Fabozzi sin-stock study: 37 years of data across 21 countries - The study, dated in the transcript as around 2008, reportedly found sin-stock excess returns in all 21 countries and double-digit excess returns in 16. Vice Fund inception: 2002 - The fund’s stated focus includes global tobacco, alcoholic beverages, gaming, and aerospace and defense.

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: Summarizes the potential return trade-off implied by the theory that ESG exclusions increase the financing costs of controversial companies. "This argument is not that you're improving the world by your style of investment, it's instead saying that the world is changing on its own and you're investing in the future winners and so should expect to outperform." — Patrick Boyle: Distinguishes the investment case for anticipating social change from the claim that ESG investing causes that change. "Sin stocks generated excess returns in all 21 countries, and double-digit excess returns were achieved in 16 of them." — Patrick Boyle: Reports the headline result of the historical study of sin-stock performance discussed in the episode.

Implications: Investors should distinguish ESG’s ethical and real-world impact claims from its return forecasts. Exclusions may create opportunities for willing investors but also expose them to meaningful risks; performance comparisons depend on sector weights, time periods, and whether higher returns compensate for those risks.