Good Intentions

Good Intentions

September 2022

The political problem of mankind is to combine three things: economic efficiency, social justice and individual liberty. John Maynard Keynes

Item YTD Change
Dow Jones Ind Avg -13.29%
S&P 500 Index -17.02%
EAFE Foreign Index  -21.21%
Emerging Market Index -19.31%
Barclays Agg Bond Index  -10.75%
10-Year Inflation Forecast 2.47%
Unemployment Rate 3.7%

*Market index data as of 8/31/2022

Redlining is generally described as a discriminatory practice in which lending and/or services are withheld from neighborhoods deemed to be hazardous or unworthy of investment. Specifically, areas with a significant number of racial, ethnic and low-income residents. Its history can be traced back to 1934, when the Federal Housing Administration (FHA), created as part of the New Deal, sought to restore the housing market after the Depression. The goal of the FHA was to incentivize homeownership by creating a government-regulated mortgage lending system. However, instead of making housing more equitable it’s policies oftentimes did the very opposite.

Uncle Sam went on to create the Home Owner’s Loan Coalition (HOLC), a federally funded program intended to help homeowners refinance their mortgages. The HOLC included in the FHA Underwriting Handbook residential security maps used to help the government determine which neighborhoods would make secure investments and which should be off-limits for issuing mortgages. The maps were color-coded Green (Best), Blue (Still Desirable), Yellow (Definitely Declining) and Red (Hazardous). As is oftentimes the case, government creates a problem, then comes along later to “fix” the problem it previously created. Thus, in 1968 the Fair Housing Act officially put an end to redlining policies that had been established by the Federal Housing Administration.

Socially responsible investing (SRI) is a well-worn term with roots that can be traced back several centuries if not millennia.  Examples include John Wesley, the founder of the Methodist movement, who urged followers to shun profiting at the expense of their neighbors. American Quakers refused to do business with companies involved in the slave trade. Shariah-compliant investing avoids investments related to activities prohibited by Islam. And many religious non-profits expressly prohibit direct investment into “sin stocks,” which typically includes alcohol, tobacco, weapons, or gambling.

SRI has been called many things over years such as best in class, sustainable investing, green investing, and values-based investing, to name a few, but really didn’t gain traction until the 1980s. Since then, the term ESG, or environmental, social and governance, was coined to encompass and stratify the many SRI terms.

Whereas its predecessors had fairly nebulous goals and objectives, ESG sought to quantify companies by way of a rating system or scorecard. ESG ratings and analyses are provided by research firms such as MSCI (Morgan Stanley Capital International), Bloomberg, Moody’s, S&P Global, and Ernst & Young. These firms are tasked with creating metrics by which to measure corporate conduct in ostensibly subjective areas such as climate stewardship, social justice, and diversity. According to a 2021 survey, roughly half of US institutions incorporate ESG scores into their investment process.

Business schools extol the concept of factors of production, which refers to the inputs required to produce goods and services. Those factors being land, labor, capital, and entrepreneurship. Deprive any business or industry of even one of these and they will cease to exist. I would propose there is a fifth and equally important factor; a system of government that recognizes rule of law and property rights, both of which are inextricably linked and essential to a free and democratic society.

For over two centuries the US has enjoyed the benefits of its robust capital markets, which provide funding for companies, roads, schools, dams, bridges, and the like. But as of late, ESG has been under fire for allegedly undermining a system that historically allocates capital based on economic merit, and instead, redirects funds to projects of dubious value. By restricting access to capital, critics claim the ESG movement is nothing short of crony capitalism, effectively threatening not just companies, but entire industries. They assert institutions that control capital (central banks, commercial banks, insurance companies, investment companies, pension plans, endowments, etc.) are being dissuaded from investing in companies and projects that serve the public good, and instead, coerced into funding companies that do the very opposite. Essentially, poorly scored companies subsequently suffer from a loss of investment, while highly scored companies receive substantial capital in-flows, effectively paving the way for a thousand Solyndras to bloom.

Detractors further proclaim that while ESG objectives sound noble if not virtuous, the end result is less innovation, higher costs, reduced prosperity, and lower living standards. They further assert that while a (free) market system democratizes capital, ESG does the very opposite; centralizing power and control in the hands of the powerful few, effectively restricting social and economic opportunities for individuals around the globe.

On the surface, corporate governance appears a fairly straightforward affair. But while shareholder capitalism establishes a clear hierarchy of loyalty and due care, the stakeholder model does not, creating potentially conflicting allegiance to/between the various stakeholders. Is corporate management best serving its stakeholders by embracing ESG goals and standards? Perhaps. However, last month a shot was fired across the bow of Blackrock, when nineteen attorneys general signed a letter asserting the mega investment firm’s ESG policies were a clear breach of fiduciary duty.

No one can argue that the spirit and intent of ESG is good. But whereas leaders in corporate ethics, such as Patagonia, Milliken and Co, and Ecolab achieved global recognition for governance and stewardship voluntarily, the prevailing means by which to achieve ESG compliance is nothing short of a cudgel. Depriving non-compliant companies of capital is a form of corporate redlining if not economic subjugation. If we learned anything from the past it’s that even the best of intentions always come with unintended consequences.

Mark Lazar, MBA
Certified Financial Planner™
Pathway to Prosperity