Academic and financial experts have long disputed Eugene Fama’s Efficient Markets Hypothesis (EMH). Is it impossible to consistently beat the market? Fama argues yes – market prices fully reflect all available information, making it virtually impossible for active managers to outperform. The increasing presence of index funds lends credibility to EMH. In contrast, investors to the like of Warren Buffet and events such as the stock market crash of 1987 question EMH’s accuracy.
Today, the debate for active vs. passive management endures on. Nonetheless, Efficient Markets Hypothesis has wiggled its way into ESG-investing discussion. Skeptics of ESG-investing reference EMH, contending that because markets integrate all pertinent information into stock prices, if ESG issues were truly relevant they would already be priced in. The counterargument is that ESG issues are not yet fully and accurately reflected in prices.
I am convinced there is ample inefficiency in the market, particularly when it comes to Environmental, Social, and Governance (ESG) issues. Due to unanticipated social and economic events, asymmetric information, and the difficulty of quantifying externalities, it seems reasonable to conclude that ESG issues are not fully priced in.
History has exhibited that the market tends to avoid or ignore issues until faced with abrupt crisis: a lost lawsuit, legal challenge, government action, or act of violence. In hindsight, any investor that had anticipated Tyco, Enron, or the asbestos disaster would have gained tremendously. The reactive behavior of the market proves the ex-post incorporation of ESG issues into stock prices. The coal and tobacco industries illustrate that the anticipation of change in sustainable issues has an effect on investment return. To overlook timing in assessment of risk would be foolhardy.
Negative externalities from pollution, depletion of resources, potential natural disasters, poor governance, and safety hazards are not acknowledged or accounted for by their instigators. Why would they be? Among other reasons, Government has not used political willpower to impose these costs on their drivers.
Consider inter-generational costs. Conceivably, companies that fail to adhere to environmental, social and governance standards are destroying the environment for future generations.
All of these costs are extremely difficult, if not impossible, to quantify. What cost should be imposed on companies for contributing to global warming and the destruction of our planet? Some companies are potentially putting us over the edge of geothermal disaster. How does one quantify the cost of human life?