“ESG is a scam. It has been weaponized by phony social justice warriors.”
-Elon Musk, May 18, 2022 on Twitter
Over the last decade, a growing craze in investing has been the ESG movement—investing in companies based on their Environmental, Social, and Governance practices. Such practices differ depending on whose definition one is using, which is part of the problem, but this generally involves a firm’s activities to reduce its carbon footprint (E), its attention to diversity and inclusion (wokeism) among its stakeholders, particularly its employees (S), and the practices of its leadership and Board of Directors (G). While individual investors are free to invest in whatever they want and free to vote on shareholder proposals however they like, in today’s investing environment, most investing and voting is delegated to portfolio managers. Pension plans and mutual funds allocate a significant portion of the capital in our financial markets, which firms rely on to fund their investments. Thus, portfolio managers have a great influence on which endeavors are funded, and they are often the pivotal voters on shareholder proposals. Progressive fund managers are using other people’s money to drain capital from key American industries and undermine the direction of our economy. As we discuss below, the intended result is the underfunding of energy and national security companies that provide the fuel and protection American families need to live, stay safe, and realize their potential. Recognizing this potential threat, the Department of Labor under the Trump Administration implemented a rule to limit the nefarious activities of ESG fund managers. The Biden Administration quickly reversed those policies and is now targeting American industry with legislative goals such as the Green New Deal and SEC rules that would embolden the ESG titans. In short, the liberal elite has now taken the reins in many corporate boardrooms, and average American investors have lost control over their retirement finances. Countering ESG efforts is one of the key consumer protection issues of our time.
At the core of corporate governance is the concept that economists call a principal/agent problem. Whenever there is a delegation of decision-making, will the person making the decision (the agent) act in his own interest or in the interest of the ultimate beneficiary (the principal)? Ultimately, companies are owned by individuals (principals) and should be operated with their interests in mind. However, a modern corporation is incredibly complex and has potentially millions of shareholders. It is neither possible nor practical to inform them about and have them vote on every decision the company makes. Therefore, the governance structure is one in which the shareholders elect a Board of Directors and the Board hires, incentivizes, monitors, and potentially terminates senior management (agents). Day-to-day operating decisions are made by those senior managers. An extensive academic literature exists that examines how to ensure that companies are managed for the benefit of their owners, because the objectives of a manager may not perfectly overlap with the desires of the owners. (Shleifer and Vishny, 1997)
For decades, the premise of corporate governance is that the objective for management should be shareholder value maximization. As articulated by Milton Friedman, “in a free‐enterprise, private‐property system, a corporate executive is an employee of the owners of the business. He has direct responsibility to his employers. That responsibility is to conduct the business in accordance with their desires, which generally will be to make as much money as possible while conforming to the basic rules of the society.” (Friedman, 1970) The shareholders are the owners and residual claimants to the operations of the firm. After selling its products or services, paying its employees, taxes, suppliers, and creditors, whatever is left over belongs to the owners. If the product or service is highly successful and costs are contained, the shareholders can realize very large profits. However, if the revenues are low but the costs are high, it is the shareholders who are the first to take losses. Employees are still paid for the hours they worked, suppliers for the goods they provided, and creditors for the debts they are owed. These payments are made unless the company goes bankrupt, in which case the shareholders are wiped out, but the other claimants are still partially or fully paid out of any remaining assets of the firm. The argument in favor of maximizing shareholder value is that a company only creates value in the long run for its shareholders if it keeps its customers happy, its employees willing to continue working for the company, its suppliers voluntarily selling inputs to the company, its creditors compensated, and its regulators satisfied. Employees can always leave and work elsewhere, consumers can always purchase from competitors, and suppliers can always sell to others. It is the shareholders who have long-term capital at stake; an individual shareholder can only exit if he finds another investor to voluntarily purchase his ownership stake.
Over time, investors have moved away from direct ownership of individual stocks and instead now primarily purchase mutual funds or exchange traded funds (ETFs). The academic literature largely argues that this is driven by a desire for diversification; small exposures to many activities will be less risky than concentrating wealth in just a few enterprises. Because transaction costs are generally charged per trade (irrespective of quantity), realizing diversification for an individual shareholder is extremely expensive. Imagine for a moment that an investor wanted to purchase all 500 stocks in the S&P 500 and paid a transaction fee of $5 per stock purchased. Realizing that diversification would cost $2,500. Now imagine that 10,000 people wanted to do that. Total transaction costs would be $25 million. Consider instead the creation of a mutual fund that pooled all the money and then purchased each of the 500 stocks on behalf of the investors. Each of the 10,000 investors pay $5 to buy the mutual fund ($50,000 in total) and then the fund buys the 500 stocks ($2.500). The total cost is $52,500 instead of $25 million. The investors are just as diversified, but the total costs are reduced by 99.8%.
However, this adds a new dimension to the agency problem. We do not just have potential conflicts between the ultimate owners and the managers of the companies; now we have mutual fund managers acting as middlemen between the shareholders and corporate managers. Instead of each individual owner deciding what to own (asset allocation) and how to vote on elections for directors and shareholder proposals (corporate governance), it is the mutual fund managers who choose what stocks to hold and how to vote on behalf of the mutual fund’s investors. Note that this assumes that the buyers of the mutual fund are the ones directly investing in it. The largest pools of money are retirement funds and pension plans, which hire money managers to act as the trustee of the retirement funds, thereby adding yet another layer of agency. In either case, do mutual fund managers know the desires of investors? Or do the mutual fund managers just buy what they want and vote their personal preferences, irrespective of the desires of the ultimate owners?