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

Episode Summary

Executive Summary: In this episode, Benjamin Felix and Cameron Passmore of the Rational Reminder Podcast deliver a comprehensive analysis of ESG (Environmental, Social, Governance) investing, debunking its purported benefits and clarifying the trade-offs. They discuss the empirical and theoretical evidence showing that sustainable investing leads to lower expected returns and reduced diversification, while its social impact depends on investors accepting these lower returns. They also cover recent industry news (e.g., CalPERS firing active managers, Vanguard's asset growth) and tackle practical planning topics like retirement spending from index funds and the optimal account for paying investment fees, correcting a common misconception about paying RRSP/TFSA fees from non-registered accounts.

Main Topics: ESG Investing: Expected Returns and Trade-offs (Priority: 5/5): In-depth analysis of empirical research (Ciciretti et al., 2019; Zerbib, 2019) showing higher ESG scores are associated with lower risk-adjusted returns. Covers exclusion costs (~2.5%/yr) and integration taste costs (~1.5%/yr). Emphasizes that ESG investing must reduce expected returns to have social impact, aligning with theoretical models (Pástor, Stambaugh, Taylor). ESG Ratings Inconsistency and Diversification (Priority: 4/5): Details that ESG rating agencies have a low average correlation (0.61), causing confusion for investors and companies trying to align with sustainable goals. Energy scores are particularly inconsistent (correlation 0.29). An example: iShares ESG Canada ETF holds Suncor (oil sands) and has >16% energy exposure. Fee Deductibility and Paying Fees from Registered Accounts (Priority: 4/5): Exposes a recent Globe and Mail article's flawed advice: paying RRSP/TFSA fees from non-registered accounts does not offer a tax advantage. Clarifies that while the CRA comfort letter addresses 'advantage' rules, Income Tax Act sections 20(1)(bb) and 18(1)(u) prevent deducting such fees. Using RRSP pre-tax dollars is better; for TFSA, using the taxable account may be beneficial. Retirement Spending from Index Fund Portfolios (Priority: 3/5): Cautions against income-focused strategies (e.g., GIC ladders, dividend preference). Advocates for total return spending with a clear policy, using Monte Carlo or historical analysis. Explains that selling shares is equivalent to receiving dividends. Rebuts the idea that balanced ETFs force selling stocks when down; rebalancing mechanisms mitigate this. Active Management Trends: CalPERS and Manager Performance (Priority: 3/5): Highlights CalPERS (US pension fund) cutting external active managers from $33B to $5B due to underperformance and fees. Notes that only 12% of active managers beat the market over the past decade (using A-class funds). Discusses the 'paradox of skill' as unskilled managers exit, leaving only skilled managers competing. Behavioural Psychology: The Undoing Project (Priority: 2/5): Cameron shares insights from Michael Lewis's book on Kahneman and Tversky, discussing biases (representative, availability, anchoring). Reflects on how to apply these insights in client meetings and personal decision-making, and the challenge of organizing knowledge.

Key Arguments: Higher ESG scores lead to lower expected returns due to investor tastes and exclusion, not risk compensation. For ESG investing to have a positive social impact, investors must accept lower risk-adjusted returns. Paying RRSP fees from non-registered accounts is not tax-deductible; using pre-tax RRSP dollars is more efficient. Dividends are not a special source of returns; total return and portfolio value matter, not share count. Retirement spending should be based on a plan, not on dividend policy or GIC ladders. Active management faces a 'paradox of skill' where remaining skilled managers compete, reducing alpha prospects.

Data Points: ESG rating agency correlation: 0.61 - Average correlation among five prominent ESG rating agencies, compared to 0.99 for credit ratings. Exclusion cost (expected return reduction): 2.5% per year - Difference in expected returns between excluded (neglected) stocks and included stocks (Zerbib, 2019). ESG taste cost (expected return reduction): 1.5% per year - Premium for investor tastes in ESG integration strategies (Zerbib, 2019). Percentage of active managers outperforming: 12% - Over the past decade (according to S&P SPIVA report using A-class funds). CalPERS external manager cuts: $33B to $5B - California pension fund reduced number of external active equity mandates from 17 to 3. Vanguard assets under management: $6 trillion - Vanguard became the first asset manager to break this mark; net sales $268B in 2019. Energy sector ESG rating correlation: 0.29 - Lowest sector correlation among ESG rating agencies, leading to index inconsistency.

Pivotal Quotes: "The spending policy should not be dictated by the dividend policy of the companies that you own." — Cameron Passmore: While discussing retirement spending from index fund portfolios and the fallacy of income investing. "For the whole thing to work, if you actually want to have an impact, it is going to work because you're getting lower demand for the securities means lower cost of capital, easier to raise money, lower expected return." — Cameron Passmore: During the ESG discussion, explaining the mechanism of social impact through lower expected returns. "Receiving a dividend is no different from making your own dividend and selling some stock. It's tautology. Yes." — Benjamin Felix: When countering the belief that selling shares harms future returns compared to receiving dividends.

Implications: For investors: ESG investing requires accepting lower expected returns; fee payment strategies must consider tax rules, not just advantage rules. For the industry: ESG ratings need more consistency; the move toward indexing and passive investing continues. For retirees: a total-return spending policy based on Monte Carlo is superior to income-focused strategies. Understanding these trade-offs is crucial for sound financial decisions.