By Arthur G. Swalley, CIMA®, Partner, Director of Investments

Principle-based investing has a history stretching back at least to the early 1970’s, when the District of Columbia’s public employee pension plan wanted to hire the Capital Group from Los Angeles to manage their funds. Capital Group’s main fund, the hugely successful and popular Investment Company of America, owned many tobacco and alcohol stocks. The District was bearing direct witness to the damage tobacco and alcohol did to the community and did not want to own the stocks. To earn the business, Capital Group agreed to set up a new fund, Washington Mutual Investors, that avoided tobacco and alcohol.

Around the same time, other Vietnam war-era funds like the Pax funds began employing strategies that avoided defense firms. By the 1980’s “socially responsible” investing was a small subset of the money management industry. In general, investors in these strategies were more interested in the expression of their views than superior investment returns, because tobacco and defense stocks enjoyed market leading performance and prominent weightings in broad market indices.

As the decades progressed and the environmental impact of fossil fuels and carbon emissions became more and more evident, many socially responsible strategies included fossil fuel companies in their screens. Concurrently, some corporations became more aware that their target markets included many diverse communities. These companies saw value in diversifying their governing board representation to advocate for their end customers more effectively, potentially increasing their sales and profits.

Gradually, these components of screening were combined under the industry moniker “ESG” – Environmental, Social, Governance. As the constituency for this approach grew, so did the investment potential. Corporate America began to invest in alternative power sources as the cost of solar, wind and electric power options came down, in concert with government subsidies like the $485 million dollar loan made to Tesla in January 2010. Tobacco usage plummeted over the decades thanks to raised awareness of its health risks. Corporate boards increased their diversification efforts to engage with underserved communities and new potential markets. ESG investing began to outperform on an absolute basis as their components made up larger segments of the broad market indices and benefitted from the subsequently increased investor demand.

From 2017 until the end of 2021, ESG investments, led by Tesla, enjoyed exceptional relative performance. The pull of Tesla’s extraordinary success led to a boom in investment in speculative electric car makers, solar and wind companies, alternative fuel producers, and performance-chasing behavior in all ESG categories. ESG entered the investment mainstream with an explosion of mutual funds, ETF’s, and institutional mandates.

Inevitably, the ESG boom ended with a bust. Overinvestment and failed speculation led to poor returns as interest rates rose in 2022, increasing the cost of capital and reducing expected future returns. At the same time, a backlash of political pressure rode the wave of declines in values to call the fundamental goals of ESG investments into question. Being used as a populist political football is a good measure of ESG’s relevance and influence on modern investing.

Interestingly, as with investing in general, political analysis has had little correlation with ESG investment success. In 2016, Republicans campaigned on a “Drill, Baby Drill” platform emphasizing fossil fuel extraction as a policy priority. During the ensuing Trump administration, ESG mandates wildly outperformed fossil fuel returns. When President Biden took over in 2021, increased investment in clean energy was prioritized. Today, we are producing fossil fuels at record levels and returns for clean energy concerns have plummeted. Making investments based on politics can be hazardous to your wealth!

Technological innovation has led to the ability of investors to construct custom indices with relatively low amounts of capital. Custom indices allow investors to specify companies to be excluded from their index. Thus, any view across the spectrum, from faith-based to ESG, can be efficiently dictated and executed into a customized index with specific lot tax control.

Investors have more ways than ever to express their views across the spectrum of beliefs. At Arlington Financial Advisors, we believe the most important belief is in the power of companies’ innovation, discipline, and diversification to deliver the returns investors need – no matter what strategy is used.