Over the past few years, ESG, or socially responsible, investing has become almost insanely popular. According to the Forum for Sustainable and Responsible Investing, ESG – which stands for environmental, social, and governance – now accounts for one-third of all U.S. investment assets.
At the same time, however, the term itself has become so general that it has lost much of its meaning. The Forum defines ESG investments as those for which a manager has considered “ESG issues” in their “research, analysis and decision making,” which sounds not just vague but an awfully low bar.
ESG investing has risen so fast that some analysts see a bubble developing, a conclusion that can be drawn from a widely read economic paper last year by the Swiss researcher Philippe van der Beck. He found that ESG returns are “flow-driven,” that is, they have resulted from money pouring into the sector rather than from companies’ performance.
A big problem is the lack of sophisticated equity analysis by ESG portfolio managers and by the researchers who build the indexes on which most socially responsible funds are based. Many traditional ESG funds, for example, practice simple disqualification – a crude method of choosing a portfolio.
BlackRock, the world’s largest asset manager, offers several iShares exchange-traded funds that screen out companies in businesses that involve gambling, fossil fuels, handguns, alcohol, conventional military weapons, genetically modified organisms, nuclear power, and even palm oil. The Vanguard FTSE Social Index fund uses an exclusionary system to “weed out companies operating in controversial businesses” or fail to meet “diversity requirements.”
This approach is so simplistic that it misses companies that have taken impressive steps toward social transformation. For instance, Philip Morris International (PMI) may be a tobacco company, but it has bet its entire future on shifting operations so that it will derive half its revenues by 2025 from smoke-free products that are much safer than cigarettes and help smokers eventually quit.
It's clearly time to go beyond ESG in determining businesses that are good investments. Bobby Yazdani, an Iranian immigrant, who runs the San Francisco-based technology investment firm Cota Capital, with $1 billion under management, has coined the phrase, “Money needs religion,” a reference to an investment approach that depends on an ethical framework to funnel capital into companies that “measurably advance the betterment of society.”
Finding such companies is hard. And when his firm finds them, Yazdani says, Cota offers “knowledge capital,” a combination of financing and a deep technical understanding of often complex technology. These elements, unified behind a core set of principles, can take businesses to scale and build what Yazdani calls “timeless companies.”
Perhaps the most successful “Beyond ESG” investment manager is Jerome Dodson, a former foreign service officer who founded Parnassus mutual funds in 1984, when ESG investing was in its infancy. According to Barron’s, Dodson is one of “a handful of managers who have beaten the S&P 500 index over virtually every period going back more than 20 years.”
Rather than following dogma or someone else’s index, Dodson became successful through intensive analysis in a search “for companies that also treat people and the community well.”
Dodson’s flagship fund, Parnassus Core Equity, is ranked in the top 1% of the 595 funds in its category for performance over the past 15 years, according to Morningstar, beating the S&P 500 by a remarkable 1.6 percentage points annually, on average. Like Cota Capital, the Parnassus group is a heavy investor in technology and health, but it also puts large sums into companies like PepsiCo, which may make sugary soft drinks and Doritos but also offers consumers alternatives like bottled water and Quaker Oats.
Dodson believes “the ESG bubble is ‘a little disconcerting,’” according to a Bloomberg Law article in January. “If you look at how some money managers determine if a company is socially responsible, it’s not very rigorous,” he added. “They use ESG as a marketing tactic.”
Yazdani, by contrast, uses ESG as an initial, not exhaustive, filter for identifying companies that have “religion” in addition to great tech. His first investment was Masimo, which makes health monitoring devices, including pulse oximeters and thermometers that offer continuous readings. He continues to focus on health technology as well as other areas where he sees the opportunity for improving lives, including fintech and digital infrastructure.
His portfolio includes both private companies like Vave, which makes portable ultrasound devices with wi-fi connections to let physicians get a quick diagnosis and, formerly, Truebill, which started by helping consumers manage (or jettison) Internet subscriptions and has now expanded into consumer budgeting and saving and was acquired by Rocket Companies in December 2021. Cota also invests in more than a half-dozen life sciences companies that digitize biology and assist pharmaceutical firms find new cancer therapeutics.
Dodson and Yazdani are among a handful of investment managers who are demonstrating that the next stage of ESG investing – getting beyond the lists of no-no stocks and into the world of purpose-driven businesses – may be the most profitable of all.
