MSCI RATES A STOCKS ESG QUALITIES LIKE BONDS

Recently while reviewing how MSCI (Morgan Stanley Capital International) is rating a company’s ESG (ecological, social, and governance) score I found myself thinking about the western film “The Good, the Bad, and the Ugly” starring Clint Eastwood. Morgan Stanley has devised a letter rating system for ESG just like those used to rate the quality of corporate bonds. In this note I mark a rating of AAA is good, a rating of CCC is bad, and rating of BBB (less bad) as the ugly. How these three items are weighted and measured is somewhat subjective, but in practice these qualities can be assigned a numerical quantity and scaled relative to each other. Quantitatively based ESG index funds can then use a computer to filter out a list of CCC companies to hold just those that are relatively more ecologically friendly, morally sound, and have good governance practices. For some these social and ecological ratings are the most attractive aspects of these funds, but as I have pointed out before it is the governance score which drive better returns over time. As I mentioned in my 2019-year end note Vanguard’s traditional mutual fund shares of the FTSE Social Index (ticker: VFTAX) heavily weights companies with good governance ratings in addition to their ecological and social scores. Companies with good governance have boards with processes in place that tend to restrain managers from pursuing unprofitable ventures, and they craft financial compensation packages that best align managers efforts with those of shareholders. Boards like these understand the value of making investments which do social good. Two other funds that Vanguard offers are the Vanguard ESG US stock ETF (ticker: ESGV), and the Vanguard ESG international stock ETF (ticker: VSGX). These are more easily traded versions and have been on the market for a little over two years. As an exercise in good governance for my readers, I offer some thoughts on ESG investing and what I like to call my GBU index which rates the good, the bad, and the ugly of investment alternatives.

“Investing” according to the online resource Investopedia is - “the act of allocating resources, usually money, with the expectation of generating an income or profit.”

The time spent by an investment manager/advisor thinking about and studying a particular asset (stock, bond, commodity, etc.) is an allocation of “resources” in addition to the money they invest on behalf of their clients. “Income or profit” can be monies returned from assets periodically in the form of dividends, interest, or capital gains realized. However, “profit” can mean something different than “money” if you are trying to achieve a social good. “Profit,” as defined by Investopedia, strictly refers to a financial money benefit. None the less, some may be willing to accept lower relative returns or even losses if they feel a social-good was achieved as “profit.” Investment advisors, such as yours truly, are tasked with making financial money profits for their clients. To do otherwise creates powerful conflicts of interest that fall afoul of doing good. Economists can debate the relative money value of what a good act is worth, but there are written guidelines for investment advisors and financial accountants alike as to what bad acts are. The simple math of $2 in the clients account is a greater good in financial terms than $1 may be good enough for some, but an accredited advisor is tasked with an exceptionally long list of acceptable and unacceptable methods by which that extra buck is banked. The world of investing is chocked full of moral quandaries; most reputable advisors limit the list of investments they will undertake on behalf of their clients to minimize the risk of doing a bad. Good governance in the investing world is unquestionably achieved by an investment manager/advisor when the objective of their client aligns as closely as possible with their respective profit expectations. Perhaps the most challenging and important job of an investment advisor is to help set and achieve their clients profit expectations. If a clients profit expectations can be met while earning a fee that is a “good”, right? But what if the advisor did not set their clients expectations correctly. For example, say a fund manager charges an annual fee of 2% and suggests to their shareholders they can expect a 6% return for the risk they are taking, but over the long term they only realize 4% after fees? The client takes all the financial risk, reaching for a 6% return, and the advisor gets paid regardless. Is that good, bad, or ugly? The answer is for the manager to do less “bad” by charging as low a fee as possible. One which fairly compensates the advisor for the investment of their “resources” of time and effort. Managers and advisors that can charge less than .5% of funds under management rank AAA (the good), between .5% and 1.0% BBB (the ugly), and anything over 1.5% CCC (the bad).

Well-trained advisors know their limits and only invest their client’s money in the things they sufficiently understand to achieve their stated objectives while diversifying away as much risk of loss as possible. Realistically this means diversifying away upside as well as downside risk. As an example, a client may ask an advisor to consider an “alternative” investment which appears to offer exponential upside risk. A timely subject of the “alternative” investment complex is Bitcoin, which rates as CCC on the ESG and GBU scale for a bad ecological ratings because of the extremely high energy cost to mine, bad social rating as it facilitates internet extortion and bad governance ratings because its poorly regulated and trades with extremely high transaction fees. If an advisor does not know anything about Bitcoin or how to value it, they are faced with a dilemma. It becomes the advisor’s duty to learn about Bitcoin, expending their clients’ resources in the form of fee’s charged against the client’s potential profit. If the advisor does not feel they can understand or value Bitcoin well enough to justify that expenditure of resources, they have three options. Firstly, to steer the client into something they do understand with a similar risk profile, secondly to explain the ESG issues with the investment and adjust their clients’ expectations about risk and return, and thirdly to steer the client to a different advisor who understands Bitcoin and its ESG issues. These are the less bad, ugly alternatives.

Vanguard charges some of the lowest fees in the industry so one could reasonably argue that just about all Vanguard funds fall into the AAA category – of ESG or GBU investing. Enjoy the summer!

*The percentages reported are year to date - June 25, 2021. The TWI 60/30/10 ETF PORTFOLIO is my custom 60 % stock / 30% bond / and 10% cash blend of Vanguard indexed based ETF's. The SPY is the S&P 500 trust ETF. The BND is Vanguards Total Bonds Market ETF.

Invest Wisely!