A recent analysis by RBC Capital, highlighted in the Wall Street Journal, observed that the top five holdings of ESG stock funds were Microsoft, Google, Visa, Apple, and Cisco.

If your reaction to that is “I thought I was investing in an ESG fund, not a tech fund“, congratulations! You just figured out the big myth about ESG funds.

They are not a way to invest in companies that actually care about ESG. They are a way to invest in what’s popular and make big sector bets. Technology stocks have been the best performing stocks over the last decade. Energy stocks have been the worst.

ESG stocks naturally avoid energy investments. This is understandable. There is no logical reason to overweight technology. In fact, there are many reasons to avoid tech companies.

But, ESG funds justify their existence on the premise that companies that are ESG friendly outperform. Thus, you can have your cake and eat it too! In order to sell more ESG product, it is in the fund’s best interest to chase performance and cut corners on ESG standards. What better way to do this than loading up on tech?

So, the secret to ESG fund performance in recent years hasn’t been that doing good produces good returns. Rather, it was that they made a giant sector bet to go long tech and short energy. That is a pretty flimsy platform for building a sustainable (no pun intended) track record.

Why Is Tech Not ESG Friendly?

First, I wouldn’t uniformly say tech is or isn’t ESG friendly. It’s a company by company evaluation. That already puts me one step ahead of most ESG purveyors!

I’m going to focus on Apple at the moment. You probably saw Apple missed earnings last week due to the coronavirus. One of the reasons was disruptions to phone production due to its heavy reliance on Chinese suppliers.

In fact, by at least one measure, more of an Iphone is made in China than the US. What does this have to do with ESG? Well, that requires a little bit of creative thinking.

Global Supply Chains Are Bad For The Environment

Apple has an immensely complex supply chain. It sources parts from all over the globe, assembles them in pieces in other places, and then brings the various components to China for final assembly.

The argument for doing it this way is, of course, that it is cheaper and therefore your phone costs (slightly) less. However, it is only cheaper if you ignore non-financial costs.

What is the environmental impact of flying parts all around the world for the different aspects of assembly? In some cases, parts start in China, go someplace else for the next leg, then come back to China for the final package.

While Apple certainly accounts for the financial cost of this transportation, what about the pollution cost? How much oil is burned in next day air shipments or even slow moving cargo ships? Not to mention that Chinese factories aren’t held to the same pollution standards as those in the US.

If Apple produced all its phones in North America, it could dramatically reduce its environmental impact at likely only a small financial cost to the consumer.

Global Supply Chains Are Bad For Workers

But building phones around the world isn’t just bad for the environment. It’s also bad for workers (the S in ESG)! The social part of ESG tends to focus on issues like living wages, equal pay for equal work, diversity in the workplace, and other concerns that arise largely in Corporate America.

However, one can do an end run around these issues by sending jobs overseas. Nobody asks about workers’ rights in Asia. If you complain about having to work too many hours or for too little to pay, you’ll need to find another job. Safety standards are better than they used to be, but still nowhere near OSHA standards.

There are certainly no diversity requirements in Asia and I would guess nobody is speaking up about any sexual harassment that takes place.

So it’s great to measure progress on social measures in the US, but any progress here may actually be entirely offset by the lack of standards for overseas workers. It’s a cheat code to game your ESG rating. If companies really care about doing right, they would move more jobs back to the US and hold themselves to a higher standard.

Global Supply Chains Are Bad For Governance

It goes without saying that China doesn’t care about stakeholders’ rights. The only stakeholder that matters to a Chinese manufacturer is the Chinese government. If a group were to advocate for better treatment of their special interest, they would likely find themselves in the crosshairs of the Communist Party!

There are no requirements for board member diversity or checks on CEO compensation. There is plenty of business that gets conducted through bribes and other forms of corruption. Basically, governance standards, as US investors have come to know them, don’t exist.

Corporations should also consider that conducting business with China, and thus with the Chinese government, enables the government to promote their agenda. Thus, choosing to save a few pennies on assembly implicitly supports human rights abuses, repression of speech, and the administration of a police state. (And, this blog just got banned by the Chinese censors!)

Once again, if you care about ESG, you would not let your company outsource their manufacturing. Bring it back home!

ESG Should Properly Measure Costs and Benefits

This is all a long way of saying that it’s a lot easier to find ESG friendly investments when you turn a blind eye to all the ESG harmful actions companies take to boost their profitability. It’s not so different from when CEOs fly across the Atlantic to Davos in a private jet to give a speech on climate change.

If companies really care about ESG, they would either require foreign suppliers to follow the requirements they insist on for US companies…or they can move their business back home.

Either way, margins will be lower. And if margins are lower, the stock price will be lower. And if the stock price is lower, ESG stocks won’t “outperform” anymore.

Not Just An Apple Issue

This is about more than just Apple. It applies to all US corporations with largely outsourced supply chains.

I only highlight Apple because it’s easiest to visualize all the contradictions in the massive transportation costs they (and their suppliers) incur without any consideration for the environmental impact. The hypocrisy of taking advantage of foreign workers while trumpeting how progressive their US work force is only compounds the sin.

I should be clear I’m not advocating collapsing supply chains. I’m also not in any way suggesting free trade is bad for the US.

I am merely pointing out the inconsistencies in the ESG mindset, as well as that to be pro ESG, you should probably be anti-trade, not out of protectionist sentiment, but because the financial benefits of trade are outweighed by the ESG costs, at least until the rest of the world catches up to our standards.