Sustainable Investing, Retiring on Index Funds, and Fee Location (EP.82)

Episode Summary

Executive Summary: This episode covers three major themes: behavioral psychology from Kahneman and Tversky, the economics and trade-offs of ESG/sustainable investing, and practical retirement spending/fee-planning issues. The hosts stress that ESG may align with values but likely comes with lower expected returns, less diversification, and ambiguous screening standards. They also clarify that retirement spending should be based on total portfolio return, not dividends, and that paying registered-account fees from taxable accounts is often misunderstood.

Main Topics: Behavioral psychology and the legacy of Kahneman/Tversky (Priority: 4/5): The hosts discuss Michael Lewis’s The Undoing Project and how Kahneman and Tversky’s work on heuristics and biases shaped modern behavioral finance, with examples like anchoring, availability, and representativeness. Institutional shift away from active management (Priority: 4/5): They examine CalPERS cutting external active equity mandates, citing underperformance and fees, and connect this to broader flows out of active management and the paradox of skill. ESG investing: trade-offs, returns, and social impact (Priority: 5/5): A deep dive into whether sustainable investing lowers expected returns, reduces diversification, and actually creates social impact through cost of capital effects, while also highlighting the ambiguity of ESG definitions and ratings. ESG ratings inconsistency and implementation problems (Priority: 5/5): They explain that ESG rating agencies often disagree substantially, creating uncertainty about whether an ESG fund really matches an investor’s values or changes corporate behavior in the intended way. Spending from an index-fund portfolio in retirement (Priority: 4/5): They argue that retirees should set spending based on total return and risk, not dividend policy, and that selling shares is economically equivalent to receiving dividends. Where to pay investment fees from (Priority: 4/5): They critique an article suggesting all fees should be paid from non-registered accounts, clarifying that deductibility and tax treatment differ by account type, especially for RRSPs versus TFSAs.

Key Arguments: Kahneman and Tversky’s research remains foundational because it explains systematic judgment errors that still affect investors and advisors. CalPERS’s move away from active managers illustrates the statistical reality that weak managers are often the ones left behind as capital exits active strategies. ESG investing can be emotionally and socially appealing, but it likely comes with a lower expected return and less diversification because investors accept lower returns for preferred firms. The social-impact mechanism of ESG works by lowering the cost of capital for favored companies and raising it for excluded companies, which implies a return trade-off. ESG ratings are inconsistent across providers, so investors may not actually be buying what they think they are buying. If everyone shared the same ESG preferences, there would be no ESG premium or market segment; dispersion of preferences is what creates the effect. Retirement spending should be driven by a sustainable withdrawal rate, not by whether cash flow comes as dividends, interest, or share sales. Selling shares to fund spending is not economically worse than receiving dividends; total portfolio value and future returns matter, not the share count. Fees for RRSPs and TFSAs are often misunderstood: paying from taxable accounts does not make RRSP fees deductible, though it can make TFSA fee payment preferable. The discussion of fees hinges on two separate tax issues: where fees are paid from and whether they are deductible; these are not the same thing.

Data Points: CalPERS external manager mandates: Reduced from 17 to 3 - The California pension fund cut most external active equity managers and brought more assets in-house. CalPERS active allocation cut: $33 billion to $5 billion - Assets under external active management were sharply reduced within the $380 billion pension system. CalPERS total assets: $380 billion - Size of the California Public Employees’ Retirement System discussed in the active-management news segment. U.S. professionally managed assets in sustainable strategies: 25% - Start of 2018 estimate cited to show the growing scale of sustainable investing. Canadian sustainable assets: $2.1 trillion CAD - Professionally managed sustainable assets in Canada, described as about half the managed market. Canadian sustainable asset growth since 2016: 42% - Growth rate of sustainable assets in Canada over that period. Global firms in ESG-return study: 5,972 firms - Sample size in the 2019 paper examining ESG scores and stock returns. Study period for ESG-return paper: 2004–2018 - Time frame used in the global ESG regression analysis. Monthly return effect of ESG score: 0.13% per standard deviation - A one-standard-deviation decrease in ESG score was associated with higher monthly expected returns. Exclusion premium: 2.5% per year - Zerbib’s estimated expected-return difference related to excluding certain stocks from ESG portfolios. Investor-tastes premium: 1.5% per year - Expected-return effect associated with investor preferences for sustainability/ESG integration. ESG ratings correlation: 0.61 average - Average correlation among five major ESG rating agencies in the ratings-disagreement paper. Credit-rating comparison correlation: 0.99 - Moody’s vs. S&P correlation used as a benchmark to show how much less consistent ESG ratings are. Energy-sector ESG rating correlation: 0.29 - A particularly low-agreement area among ESG raters, used to explain differences in index holdings. iShares ESG portfolio cost: 28 bps - Approximate fee for a globally diversified ESG ETF portfolio in Canada. Comparable non-ESG portfolio cost: 12 bps - Approximate fee for a similar non-ESG iShares ETF portfolio in Canada. Vanguard net sales in 2019: $268 billion - Net sales for Vanguard cited from a Financial Times article. BlackRock sales pace: $300 billion in first nine months of 2019 - Used to show BlackRock overtaking Vanguard in sales pace for the first time in seven years. Vanguard sales mix: 20% equities / 60% long bonds / 20% money markets - Illustrates clients’ defensive behavior after the 2018 market selloff.

Pivotal Quotes: "the portfolio with a lower expected return buys By definition, how assure you that it actually reflects your views and values?" — Benjamin Felix: Introducing the central ESG trade-off between values alignment and expected returns. "The premium for investor tastes is related to the cost of externalities that sustainable investors internalize to maximize their welfare instead of the market value of their investments." — Benjamin Felix: Explaining why ESG preferences can lower expected returns while producing social impact. "Dividends are not returns." — Cameron Passmore: Retirement spending discussion emphasizing total return over income labels.

Implications: Investors should treat ESG as a values-based choice with real portfolio costs, not a free lunch. Retirees should plan spending from total returns, and fee-payment decisions need account-specific tax analysis rather than simplistic rules.