An anecdote on the trade off in ESG investing

I often mention that there are three reasons behind ESG or sustainable investing: possible long term financial performance in the right companies; making a societal impact through the investment; aligning personal beliefs and values with investments.

These three objectives may not be achieved at the same time. Aligning personal beliefs may have a trade off with possible financial performance on the investments. Moreover, these ESG objectives may have a trade off with the basic goal of investments: producing long term return at a suitable level of risk.

I have a friend who is a strong believer in AI. He has been holding those well known AI technology names in the US for a couple of years. In fact, his asset allocation is really in one stock market: US. The AI story has worked well for him.

There is another reason why he focuses almost exclusively on US stocks. He has a strong (political) view about China and Hong Kong. Since 2020, he sold all the investments in that region and put them in the US. Whenever I talked to him, he cited his “S” (social) and “G” (governance) principles in excluding Chinese stocks.

But when I saw him a few days ago, his view seems to have changed. He is getting worried about the valuation of US stocks, including the AI names that he is holding. Also, he recognizes that the world has moved: from one that is linked through global trading, to one that is dominated by two or three power spheres. Similar “polarization” also happens to AI. The US approach to AI is markedly different from China, with the latter encouraging companies to release AI models as open-source to the public. In addition, the protectionist approach by Trump on technology means that there can be different standards and approaches in implementing AI in the West and in Asia. Which means AI investment opportunities may not just be in the US.

For example, let’s compare the 3-year share price performance of 3 chip companies: NVDIA, Taiwan Semiconductor, and the Chinese Semiconductor Manufacturing International Corp (SMIC) that is listed in HK (see chart below). The strong performance of NVDIA means its valuation looks stretched. SMIC has been a laggard. But will the AI needs of China without the US chips technology make this company a good investment opportunity?

Source: Tricio Investment Advisors Ltd.; all price returns are in local currencies

I reminded my friend that there are many Chinese AI companies going to list in Hong Kong soon (see for example this FT article – subscription required).

He concluded: “Even though I have not changed my political view and beliefs, it looks foolish not to reconsider China and Hong Kong on AI and related industries.”

The main point of this story is not about any stock recommendation. Rather, this discussion with my friend led me to think about investor behaviour when it comes to ESG investing.

First, making investment decisions that align with your beliefs comes with a cost. That cost can be long term return opportunities. The trade off with the basic goal of investments sometimes is too strong to compromise.

Secondly, excluding companies, sectors, or markets in ESG investment can introduce concentration risk in portfolios. For example, see my friend’s inadvertent overweight in US stocks where valuations look stretched.

Thirdly, there is nothing wrong with making investment decisions that align with one’s beliefs. Equally, there is nothing wrong with reconsidering this alignment when the portfolio does not make investment sense.

Being too stubborn may not be a virtue in investment.

James Chu CFA, Head of Investment Solutions