Guest User

March 17, 2022

ESG, Expected Returns, Portfolio Management

Episode 192: Prof. Alex Edmans: Growing the Pie: A Different Take on ESG

Guest User

March 17, 2022

ESG, Expected Returns, Portfolio Management

Alex Edmans is Professor of Finance at London Business School. Alex has a PhD from MIT as a Fulbright Scholar, and was previously a tenured professor at Wharton and an investment banker at Morgan Stanley. Alex has spoken at the World Economic Forum in Davos, testified in the UK Parliament, and given the TED talk “What to Trust in a Post-Truth World” and the TEDx talk “The Social Responsibility of Business” with a combined 2.4 million views.

Alex’s book, “Grow the Pie: How Great Companies Deliver Both Purpose and Profit”, was featured in the Financial Times list of Business Books of the Year for 2020, and he is a co-author of “Principles of Corporate Finance” (with Brealey, Myers, and Allen) for the 14th edition to be published in April 2022. He was named Professor of the Year by Poets & Quants in 2021.

We always appreciate research-based arguments here at the Rational Reminder and when those arguments might rattle some assumptions we get particularly excited. Today we have an eye-opening conversation with finance professor Alex Edmans, in which he discusses his idea of growing the pie and how social change and value relate to investor decisions. Alex's work is deeply rooted in skepticism and a critical method of assessing evidence, an approach that has resulted in surprising and sometimes paradoxical findings. We get into a fascinating conversation dealing with employee satisfaction and ESG, with Alex challenging some commonly held beliefs around socially responsible investing, with the data to back it up. A strong theme that emerged during our chat is the need for these conversations to be grounded in research, instead of empty rhetoric, and Alex's data-rich perspective is a great inspiration. Towards the end of the episode, Alex talks about the practical, individual application of his ideas, and how an empowered employee can add value on any level. So, to hear all this and a whole lot more unmissable insight, join us on the show.

Key Points From This Episode:

Unpacking what Alex means by 'growing the pie' and differentiating this from other similar-sounding goals. [0:02:38]
How to go about measuring the growth of the pie, and the pieces that cannot be measured. [0:05:14]
Alex addresses Milton Friedman's famous quote about responsibility and profits. [0:06:48]
The role of big asset managers in directing investment towards more socially responsible causes. [0:08:56]
Thoughts on the value of divestment as a means to effect social change. [0:11:34]
How much impact are typical ESG funds having currently? [0:15:05]
The subjective discussion around sustainability and Alex's definition of what makes a company sustainable. [0:17:06]
The inconvenient truth about sustainable funds' performance against the market. [0:20:56]
Alex's research into the relationship between stock returns and employee satisfaction. [0:22:23]
How to take a quantitative approach to employee satisfaction as an investor. [0:29:16]
The practical application of information about happy workplaces for investors. [0:32:51]
Alex's input on the problems associated with executive pay. [0:35:18]
Counter-arguments to some of Alex's unpopular opinions and positions. [0:39:52]
Tackling the tricky subject of board diversity at organizations. [0:41:27]
Finding trustworthy evidence in the contemporary climate and combatting the post-truth era. [0:46:22]
Using Alex's idea of growing the pie in everyday life; making the world better on an individual level. [0:48:46]
The left-field study that Alex conducted linking Spotify playlists to stock performance. [0:52:16]
Alex's perspective on his role as a finance professor and his purpose with regard to knowledge. [0:56:38]
How Alex looks at success in his life and his goal of positively impacting people. [1:00:12]

Read the Transcript:

Alex, your book is titled Grow the Pie, can you tell us about the difference between growing the pie and maximizing profits?

Sure. Let me first start by explaining what the pie is. So the pie is the amount of social value that a company creates and that value can be split between investors in the form of profits or society in the form of taxes to the government, wages to workers or fair prices to customers. So often when people think about, well, how do I maximize profits? They have this fixed pie mentality. So if the pie is fixed, the only way to get a greater slice for investors is to reduce everybody else's slice. And so, you could do that by paying workers as little as possible, working them as hard as possible, charging customers some hidden fees and so forth.

But, the whole idea of growing the pie is that actually, if you are to create value for wider society, for example, by treating your employees well, making them motivated and productive, that then expands the pie and ultimately your profits will go up. And, while that might seem a bit of wishful thinking to think that everybody can be better off, the heartbeat of what I try to do is rigorous academic research. And so, one of my own papers about 15 years ago looked at the link between treating employees well and long-term returns. And, it did suggest that there was a positive link between them.

And, we're going to dig into that paper or later. Can you talk about how the growing the pie mentality is different from meeting quantitative sustainability criteria?

So I think when you think about meeting quantitative sustainability criteria, that's something which is box-ticking. So you're doing it on an instrumental basis. So I am going to put a minority on the board to tick a diversity box. Whereas many things that you do to create value for wider society, they are not quantitative. So if I'm providing my employees with meaningful work and skills development and creating a psychologically safe corporate culture, wherever we can speak up and come up with ideas, that's not something which can be quantified. It's something which might not tick some boxes, but it's something that I intrinsically want to do because I want to provide an environment where my employees can flourish.

So I say the main difference is growing the pie's intrinsic. You do it because your heart is to create value for your employees, a wider society. Whereas I'd say meeting criteria is instrumental, you do something to tick the box. Using the analogy of teaching cause I'm a professor, but do you teach to the test or do you teach things that you think are going to be improving your students well-rounded education?

Interesting example. So can pie growth be measured?

There will be certain measures that you could have with it. So it could be, you'd look at things like employee turnover, employee retention, and so on, but I think there are many things that you can't mesh. And, one of the concerns I have with this more quantitative approach to ESG is people are trying to do ESG by numbers. So they're trying to have particular criteria. Can we measure those criteria? I think that as dangerous as having a teaching you by numbers approach, which I think what No Child Left Behind tried to do about 20 years ago, can we measure performance in standardized test scores in order to bring accountability? That's the same argument that people say, yeah, let's bring accountability to ESG.

But, what happens is, you hit the target but miss the point. You focus only on the dimensions that can be measured. So I would say, no, it can't be measured, but it can be assessed. And so, what is the difference is that assessment involve looking at qualitative dimensions as well. So, I know many investors, when they choose to invest in the company, yes, they'll look at some metrics, but those metrics will only be a precursor to meeting with management, maybe themselves meeting with employees and customers. And, just like when you hire somebody, yes, you look at their CV, but you would never hire them without an interview so that you can put all of these things into context.

So you can assess it, you can evaluate it. So it's not just something which is fluffy, but I would say, try not to think that you can measure it because then you're going to be ignoring some of the most important dimensions of ESG.

Wow. It's a very different perspective on ESG. Friedman famously wrote that the social responsibility of business is to increase its profits. You've got a really good take on that. What did he mean when he wrote that?

Thanks. Well, I'll first start maybe with what people think he means. If you just look at the title, that just seems offensive. The social responsibility of business is to increase profits, and maybe people think that he meant that company should just try to steal and to cheat as much as they can, as they're allowed to by the law, focus only on profits and ignore everything else. But in fact, if you read his article, it's much more nuanced than you might think.

So what he says, is that you should focus on long-term profits. Why? Because if you focus on long-term profits, that forces you to care about society, right? You can't treat your employees poorly, otherwise they'll leave. You can't pollute the environment, your brand will be hurt. So what he says, is that it is fine for a company just to focus on profits because as long as it focuses on long-term profits, it'll ensure that it gets the social decisions right now.

While I think Friedman is actually much more nuanced than many people give him credit for, I would still disagree with him for a couple of reasons. One of them is that even in the long-term, there might be certain things that won't feed through to profit, such as externalities. So in the absence of, let's say, a carbon tax, then it might be that you can pollute and not feel the implications of that.

Number two is that Friedman was thinking about an instrumental approach to decision-making. So before I choose whether to build a factory, I calculate how many widgets that factory will produce, how much I can sell it for and compare that with the cost. Now, that's possible with a factory, but if we think about an intangible investment, let's say, if I'm going to give my employees more parental leave, how much more productive will they be? How much more money will I make? That's not something you can quantify. So sort of my pie clinical approach is, again, going back to the intrinsic idea of, do this to create value society where Friedman, I still think, has this instrumental mindset.

So large asset managers like BlackRock and Vanguard have been very vocal about their efforts towards sustainability, through things like ESG funds, engagement, proxy voting. So do you think it's a good idea to have these huge asset managers trying to influence social responsibility?

Actually not necessarily. And, this might seem heresy because people think, no, this is certainly what ESG funds will do, but this was another interesting point that Milton Friedman weighed. So why did he say it's socially responsible for businesses to focus on profits because he says there's another party which thinks about wider society and that is the gut.

So the analogy might be to, let's say, a sports umpire. So let's say in tennis, as long as the umpire calls whether the ball is in or out, you are free to hit the ball with as much spin or slice or deception or power as you want to, as long as you hit it within the lines. And similarly, as long as the government sets the walls of the game, so the government could set a carbon tax, the government could ban child labor, the government could set minimum wages as long as the company is to follow that, then it's fine.

And, the important thing is that when the government sets this, the government is elected by the aggregate citizens of the economy. Everybody has one vote. Whereas if you think about the BlackBox and Vanguards, they represent the 1%, right? Who are the people who invest with them? They are the wealthy people. If you are say a coal minor who doesn't own much equity, are you somebody who's going to be represented by the Vanguards? No. So they might pursue decarbonization, which don't get me wrong, is a really important thing, but there are trade offs that could lead to a lot of people being made redundant. So one concern is actually when BlackRock and Vanguards are doing something, which actually are not necessarily meeting the aggregate preferences of the nation, than they're usurping the role of government.

Now, with that in mind, there is one thing that I do think that it is legitimate for them to act on, is if it is something that the government cannot regulate... so carbon tax, you could put in, minimum wages you can put in, but something that can't be regulated is something which you can't measure. For example, a government cannot put a regulation, say everybody needs to have a psychologically safe corporate culture because you can't quantify that. But, if some investors say, well, let's try and engage with companies to ensure that employees have meaningful work and that we have a vibrant corporate culture, then that could be something where it is sensible for investors to take action because the government regulation would not work in those cases.

That's super interesting. It kind of relates to the next thing that I want to ask you about. So we occasionally hear from investors who want to divest or not own companies in certain industries or specific companies, do you think divestment is a good way to affect social change?

Again, I think the understanding of this is quite divorced from actually how these things operate. So often people think, yes, we're such a responsible investor, we never invest in tobacco or alcohol or fossil fuels. We're depriving them of capital. But when you think about it, well, you can never sell your shares unless somebody else buys. So when you're divesting, you're not depriving your capital.

Often you think about divestment as being like a consumer boycott, but it's not. But if I boycott a company, that company does not get my revenues and it might be that nobody steps into buy from that company. Whereas you can only sell if somebody else buys. Now, it could be the case that actually, even if somebody else buys, your act of selling dries down the stock price and makes it harder for the company to raise capital. But I think that is something which is only really effective if you do what is known as tilting rather than exclusion.

What do I mean by that? Exclusion is, I'm never going to invest in any fossil fuel company, but if the investor is never going to buy it regardless, then there's no incentive for a fossil fuel company to reform itself to have a clear transition plan, because it's going to be divested no matter what. Whereas if you have a tilting strategy, which is I'm going to be negative on the sector, but if you are best in class, I'm going to be willing to hold you. That does give an incentive for a manager to be a leader in transitions.

So while it might seem to be pure to say, I'm never going to touch of this sector, it actually could be more effective to say, well, I will hold the best in class one. That's just in terms of the divestment. But a second thing which is important, is engagement where we've seen some investors, let's say, engine number one, hold X onto account by electing some private funny directors. And, they were only able to do that at because they had a seat at the table because they owned some shares and they could have some votes.

So one of the problems of divestment is that if you don't have a seat at the table and you don't have votes, then that might prevent you from engaging. So overall, often people look at these in black and white terms, that one is better than the other. I think both divestment and engagement are tools that are useful, but I would first start as an investor by trying to engage. And, only if the company is unresponsive, then I might divest from it afterwards. I certainly don't like the approach of investors saying, we are such a green fund, we never touch the sector. That would just be like a doctor saying I'm such a pure doctor, I'm never going to deal with any sick patients, I'm only going to do with healthy patients.

That's a pretty funny analogy. What would you say to an investor who just says, I don't feel good about owning oil and gas stocks. I want to divest. Is that a different conversation?

Yeah, so if indeed, the reason for divesting is from a values perspective, I just feel bad making dividends from this company, that's fine. And, you are absolutely entitled to say that. But, just don't think it's going to impact the company. So don't think that you're going to actually influence change. So there's three different reasons for why you might engage with ESG. One, to improve long-term financial returns. I know they're going to get to some of my research later. Number two, to positively change a company. That's when I think tilting your engagement is better. Number three, to reflect your values. And then yes, you might just want to do divest completely and never have anything to do with a particular sector.

Interesting. So, are typical ESG funds doing anything to make the world a better place?

I think some of them are. I know I'm sort of hedging my answer, but I think it's difficult to make sweeping statements. So like Tariq Fancy came up with his critique of sustainable investing, I do think some of the statements were well founded, but what I didn't agree with was his sweeping critique saying that every funders doing poorly. So what do I think are the ones that are doing them well? They are ones who take concentrated positions. There are some funds I know, which might own, say, 30 stocks. So they're really in the weeds of that particular company and they might understand, what are the specific ESG issues of that company, rather than let's say a GAV line investor who has their particular sort of bee in their bullet about one issue and tries to put a shareholder vote among hundreds and hundreds of companies.

So I think the ones that do their own research and make sure that their engagement is targeted are really helpful. I do think the ones who are adopting the tilting approach are useful because then that does provide an incentive to be truly best in class if you're in a problematic sector. And, the third thing, which is really important is to just be really honest about what you achieve as an investor. So I've been for six years on the Responsible Investment Committee of Royal London Asset Management, which is a leading asset management sustainability. We've been in the space for 18 years. And, we're stringent about not claiming impact.

So we will not say 1000 pounds invested in us, we'll create X jobs and save Y tons of carbon emissions. We would like our companies to do that, but we can't claim causality. Maybe the companies would've done it anyway. Yes, we do try to nudge them, but we won't claim that this is entirely down to us. Whereas there might be other funds who say, well, if you do this, you'll save all of that. But that is something which, I think, is an overclaim because you don't know whether that's something that could have happened anyway. And, I think one of the things that I did agree with the Tariq Fancy critique is there's a lot of sort of overplayed marketing, where people are making claims as ESG funds, which are much higher than what they actually achieve.

Is there any consensus either academically or in practice, with asset managers, on what constitutes a sustainable account?

Not really, unfortunately. But, I think this is not a problem because I think sustainability is inherently subjective. So what I define it as, is it's something, do you create value for wider society within Royal London will say, well, do you create a net benefit for society? And, there will be just different views. So let's say the alcohol industry, so Royal London, we're actually permissive for the alcohol industry. We think it has a positive role in society. We think a society with alcohol is better than a society with prohibition.

Right, so in a world in which relationships are increasingly fragmented and online, it's something that brings people together and encourages socialization. Within moderation, a good thing. Hopefully many of us would agree that. But, there are some people and I respect their view who say, no, we would never invest in an alcohol company. And, there's some people for religious reasons might, might not invest in such company.

And, why I think your question is such an important one is when it comes to things like ESG rating... so, you do have rating agencies like MSCI and Vijay or Iris trying to rate the sustainability of a company. And, there are people who lament the fact that, oh, these ratings disagree with each other, then there's no hope for sustainable investing if nobody can agree on what sustainability is. But, I think another word for disagreement is diversity. Different people will have different viewpoints as to what a sustainable company is.

Going back to one of the earlier questions, right, these are not things that you can measure quantitatively, but you can assess it. We could both interview the same person from our company. I might prefer to hire her and you might prefer not to hire her, but that's a variety of opinions here. So, I think we should embrace this rather than saying well, because people can't agree, then there's no hope in practicing sustainable investors.

So, are sustainable investors accepting, or even expecting lower expected returns?

So many of them are not. And, I think this is perhaps because of a misportrayal of the evidence. So maybe some false marketing by some firms. So what often people argue is that you can do well and do good. That by investing in companies that create value for society, you're going to have higher returns. And certainly that is true in many cases. That is the heart of the pie growing mindset is that many things that you can do to serve society do indeed boost long-term profits.

But, that's not always the case, right? For certain societal actions, there are trade up. So the most stark example, is if you are to donate to charity, but any dollars that I give to charity are dollars taken away from shareholder returns. Now you might think, well, does this boost my image and improvements in other ways, but any image boost is probably going to be unlikely to offset the donation. So, that is something where it is zero sum, the pies is fixed. Now, because there are some supporters of ESG who claim there are no trade offs, there are investors who think, well, let me buy into these funds, thinking I'm going to both do good and do well.

So David Blood and Al Gore, two people I greatly respect, they wrote a recent Wall Street Journal article saying, study after study, the numerous research shows that these things are always going to be intertwined when it's not always going to be the case. And, what's interesting is that some people make inherently contradictory arguments, but they don't realize the contradictions. So some people say, well, companies should be more sustainable because if they're more sustainable, the cost of capital goes down, right? Investors demand lower return for investing in a sustainable company. But then, they will turn around and say to the same investors, you're going to get a higher return from investing in a sustainable company. But, those two things cannot exist in equilibrium in the long-term, if indeed the company is getting a lower cost of capital, then investors should also be getting lower returns.

So do sustainable funds tend to beat the market?

They don't actually. So this is one of the inconvenient truths for the sustainable investing industry is if you look at any long time period, the average ESG fund does not beat the market. Now, there might be some time periods where it outperforms, but those are very hand selected. So one month into the pandemic in March 2020, Harvard Business Review published an article trumpeting, that over the last month, sustainable funds beat the market. But I think that was a really sloppy article because, let's say over the past month, you found the opposite results, sustainability had underperformed, people would say, well, one month, that's too short term to form any inferences, but just because this worked in your favor, they forgot the fact that it was only one month. And, this also did not control for industry.

So the outperformance was simply a long tech, short energy thing. It was an industry effect rather than the sustainability effect. But, when you look at the long-term data, you don't actually find that. Now then you might think, well, how can I with a straight face, come on here and talk to you about pie economics when the average fund doesn't meet the market? Well, it's because the average fund might not be looking at the correct criteria. So when you look at specific dimensions to sustainability, those are ones that do beat the market. But when you have some investors, which might be pooling together, the material factors, but also the immaterial factors, then you actually don't get outperformanced.

That's exactly where I want to go next. You add a paper, 2011 paper in the Journal of Financial Economics, where you looked at the relationship between employee satisfaction and stock returns. Why did you choose employee satisfaction?

Yeah, that's a good question. Because you might think, well, if I care about sustainability, why don't I look at carbon emissions or something like that, why employees? So this was for two reasons. First is the topic of materiality, which I'm sure we're going to delve into more later, which is employees were important in nearly company, they are a critical asset in all industries. Whereas, let's say, carbon emissions, that matters if you are in energy, but maybe in tech, that's less of a material issue.

So that's point number one is its materiality. But, point number two was data. So ESG is a pretty new thing. And, so many data sources might have only been around and for, let's say, 10 years or so. And, how do you know that those 10 years, I didn't just get lucky. Maybe those were 10 boom years from the stock market. But, I was fortunate that there was this list called the 100 best companies to work for in America. And, that list started in 1984. So between 1984 and 2011, I had 28 years of data. And importantly, those 28 years included the financial crisis, September the 11th and the collapse of the debt bubble. So I could make sure that any result that I found wasn't just due to good times, it was something which was also robust in bad times.

And why is that important? People often think that sustainability is a luxury, we should pursue it when times are good, but when times are bad, we should forget about it and focus and survive.

Yeah, it's super interesting. And so, in that paper, you've found an economically large statistically significant positive for factor alpha, which is pretty cool. What jumped into my head when I saw that is, have you looked at the Fama French 5 Factor Alpha.

So I didn't, but other people have, so that's sort of a nice answer. So what did I find in my paper? Yes. It was a 4 Factor Alpha of 2.3 to 3.8% per year, 89 to 184% compound. So that shows there's a business case for treating your workers well, not just a moral and ethical case. But then, one pushback, and there was a large asset management that came to me and said, "Yes, we're thinking about making this an important part of our investment strategy, but there's now more factors that have been discovered since you wrote your paper in 2011."

So the 5 Factor model wasn't out then. I think there's now a 6 Factor model. There's also other control variables which have been found. But fortunately, there was a paper by some professors at EDHEC in France, which, number one, that replicated my paper for the original 28 years, up to 2011, with the new factor models and showing that those results continue to hold even after adding those new factors and then replicated for the 10 years since. So even though my paper was 10 years old and you might think, well, if markets are efficient, this should now be priced in. Therefore, no asset manager should look at things like employee satisfaction. Actually, it turns out that this is something which continues to hold in the 10 years that we've seen since then.

So out of sample with respect to time, has it been tested out of sample with respect to countries?

It has. And, this is something that I have done myself with some co-authors in a working paper. So, this best companies to work for list exist in, I think, 45 countries worldwide of which 30 of them had sufficient numbers of companies that were domestic to form the test in those countries. So what I need to get rid of is say, let's say, if Microsoft is on the list and Microsoft operates in loads of different countries, I need to make sure it's unique to that country, otherwise I'm just driven by the US.

And, what I found is that the results do hold generally, but not always. So where does it hold? So in countries with flexible labor markets like Canada and the UK, I still find similar results to the US, but countries with rigid labor markets, let's say France and Germany, there is less of an effect. And so, why is that? Because if the law already requires you to have high minimum wages, maybe employees on the board, maybe restrictions on hiring and firing that's something where there is less need for a company to go above and beyond because the law is already guaranteeing a high level of employee satisfaction.

And, this is really interesting and important more generally, because often you do get lots of these academic studies being based on US data. And, we often think that this finding applies everywhere around the world, but it might not be for certain settings, particularly if what you are looking at is something which depends on the institutional context. And, here the value of employee satisfaction will depend on the level of labor market regulation.

So the obvious question, Alex, why do you think the market would misprice employee satisfaction?

Yeah, this seems crazy, right? So you might think, okay, we can accept that for 2011, but what's happened in the 10 years since. ESG has been like this massive boom area so this should be something that everybody should be copping onto. I think it's linked to one of the early questions that we ask is that people are doing ESG by numbers. So people do take employees into account, but what they might be looking at are things like the gender pay gap, the number of minorities on the board, employee turnover, CEO to work at pay ratios and so forth.

Whereas what the best companies to work for list looks at is yeah, clearly pay and benefits are important, but other things such as, do you create meaningful work? Do you communicate with your employees? Is this a place where you're getting mentorship? Do you get a fair shake if you have a dispute. Are you made to feel welcome? So a lot of these qualitative factors which really do affect how we feel as employees in our organizations, but might be missed by some blood measures on, say, pay or diversity statistics, even though obviously pay and diversity are important things, they're not everything about an employee value proposition.

So you've documented this under pricing and so have other people out of your original sample. Do you think it's going to persist? Are these alphas going to go away now that it's been published?

Just given it hasn't gone away in the 10 years since it's been published and given that those 10 years are 10 years in which there's been more focus on ESG than ever before, I'm actually quite confident that it will continue to persist and particularly given as even more focus on this ESG by numbers, right? There's more reporting frameworks coming up with common sustainability metrics. And yes, you can measure things like pay and benefits, maybe you can measure paternity leave and maternity leave on a consistent basis, but I don't think you'll ever get to measure things which are truly part of being a great place to work. What they have in their survey is credibility, respect, fairness, pride, and camaraderie. And hopefully, that will be something which will always continue to be mispriced and that's something where human investors are really important in order to try to value it and assess it.

Oh, okay. So, that was my next question. Thinking as a quantitative strategy, it sounds like this wouldn't be viable. There's a lot of subjectivity into building that list. Is that correct?

There is some subjectivity, but some people have got quite smart about this if they want to take a quantitative approach because not everybody can take this groups and the grant approach, particularly in the type of fund. So what some people have done is, they try to do calls of Glassdoor surveys. So this is where people will voluntarily report their assessments. And, there is one fund, Sparkline Capital, what they've done or they've published on the website is a very interesting table measuring culture where what they do is they use a bag of words approach. They try to extract certain words here, build those words around certain themes and use that to try to highlight the themes that are coming up in this Glassdoor evaluation process.

Unreal. So is employee satisfaction, a good measure for social responsibility?

It's only one dimension of social responsibility. So when you look at the other dimensions of social responsibility, you find a much more mixed result. So some things do work and some things don't. And, which are the things that tend to work if we go back to the material concept that I introduced earlier, there was a study published by the accounting professors in the Accounting Reviewer Top Journal, where what they did is they mapped the ESG ratings to this SASB Materiality Map and that defines what are the most material issues for a given industry.

So, yeah, maybe if you're in energy, then climate is really, really important. But, if you're at a bank, maybe what matters is customer privacy, data security, selling practices, so you don't want to be in a Wells Fargo fake bank account situation. And, what they found was that ESG pays off only if it's ESG in material issues for your particular company. And, I think this is really important because some people looked at my study and said, oh, this guy has proven that ESG investing always works. I'd done nothing of that sort. I looked at one particular dimension of ESG employees, but that didn't naturally extend to all of the different other dimensions. And, when you explicitly do that extension, you do find more mixed results there.

Interesting. But, your dimension was specifically chosen, I think, you mentioned earlier to be sort of industry neutral.

Yes, exactly. So what I wanted to come up with as a measure, which was going to be of widespread interest to all industries and investors in different industries and also it was one where there was a strong hypothesis as to why it would matter. So one of the other problems with ESG and any academic research, I know you've had Cam Harvey as a previous guest, is data mining. There's so much payoff to trying to find a significant result now.

But, because there's so many ESG dimensions you can look at, you can look at articulate pollution, you can look at nitrous oxide, you can look at carbon emissions and so on, I could mine the data and let it run a hundred different regressions trying to link ESG to returns. Now, even if there was no link, five of them could be significant at the 5% level and I could just publish those results.

So why could I try to claim that I didn't data mine, is that I only looked of employed satisfaction. How can I claim that? Because that was the one thing which has a really strong, theoretical link as to why that would matter. Whereas if I looked at nitrous oxides and found it was a result, people might say, well, why not solve oxides? And instead, how can you justify that you only looked at nitrate oxides? But, with me, I think most people would agree that human capital is the greatest asset in most 21st century companies.

Something that we haven't talked about yet, but is pretty... well, you've alluded to a little bit with your work with asset managers. I did a quick search, nothing too comprehensive, but I did a quick search for ETFs of the best places to work companies. I didn't find any. How can investors practically use the information we've talked about so far?

Yeah, sure. So there's two ways in which you can use them. So one of them is to buy a fund, which focuses on employee wellbeing. And so, there is one fund, the Parnassus Endeavor Fund. So the ticket symbol is P-A-R-W-X. It used to be known as the Parnassus Workplace Fund. And, one of the advisors was Milt Moskowitz who came up with the first best company to work for list. So I've been an investor in this fund for 15 years now. And so, Morning started a study a few years ago where they found it was the best performing large cap fund over the past 1, 2, 5 and 10 years. And, notice that was out of all funds, not just out of ESG funds. It was something where this was an ESG criterion, but because it's a mispriced characteristic, it's something that allowed it to be for traditional funds as well.

Now, what that does is, it doesn't just buy the best company's list. It does its own analysis as well, but it is something which looks at employee wellbeing. Why it's changed its name from Workplace Fund to Endeavor Fund is they also now have a fossil fuel screen on members as well. But, there might be other companies which will say we are a sustainable in general, and we're going to look at many criteria, but corporate culture is one of the things that we are going to be trying to look at more specifically. So 91 is an asset management firm where I know that they've developed a framework to assess corporate culture. And, it's one thing that they will claim to be distinctive about their approach to sustainability. It's not the only thing they'll look at, but it is a criterion that they do take really seriously.

Very interesting. I looked that fund up while you were talking, because I know our listeners are going to be curious, it's got a fee of 88 basis points, it's got a market beta of one loads to small caps, loads to value, smaller, positive load, not statistically significant to profitability, negative loading to investment. This is just using the Fama French 5 Factor model. But, it's got a big positive alpha of 2.4% going back to 2005, teased out of 1.5. So not quite statistically significant at the 5% level, but still very interesting.

Yeah. And, it's been one of the largest holdings in my portfolio. So I do put my money where my mouth is in terms of my own research.

Speaking of interesting, one of the parts your book I found interesting was where you talked about executive pay. We hear a lot about executive pay far exceeding the average employee pay and that this is a problem. So Alex, is it a problem?

Well, I think when you talk about, is something a problem, you think about it, well, what's the objective? So you might think about it's a problem for two reasons, the effect on firm performance and the effect on inequality and social welfare. So let me tackle these two things in turn. So is it a problem for performance? Well, what a lot of people will claim is that if there's a lot of discrepancy between the workers and the management, then the workers will be demotivated, they're going to be less productive, isn't just this the opposite of the pie economics the employee satisfaction i'm talking about.

Well, actually, no. And so again, what I want to do is look at the evidence. This is evidence, which is often really misrepresented. So a few years ago I was summoned to testify in the House of Commons because there was an inquiry on corporate governance. And, the witness before me, which was from the Trade Union's Congress like the equivalent of the AFL-CIO in the US. They claimed that there was research finding that the higher the pay ratio, the worse the performance because of this demotivation.

But, what they've done is they quoted a half finished study. Now, the finished version was actually published, but after going through peer review, have found completely the opposite result. And so, the point here was actually much more general is that often we hear the phase, research shows that X, but you can always find research to support whatever you want to support. So what matters is, is the paper published in a top peer review journal? So I really appreciate, Ben, you mentioning that my paper was in the Journal of Financial Economics and they forced me to rule out all of these different alternative explanations. They made me go through purgatory to publish the paper, but it did mean that once it got published, I was confident that I was able to show that it was reversed.

So, going back to the pay ratio point, that study that I mentioned when it came out and found the opposite, that was based in the US. I earlier mentioned, we can't assume that what you see in the US applies elsewhere around the world, but similar studies have found the same result in the UK and interestingly in Germany. So you might think, well, the UK, the fact that it's similar to the US, that's not surprising, they have sort of similar social norms. But, Germany, that tends to be a place which takes employee or wellbeing perhaps more seriously, they have mandatory employee board representation, but also what they found was this positive relationship. And so, why might that be?

Well, it might be that actually causality is in the other direction. But if a company is doing really, really well, then the CEO should be rewarded for it, right, because that is fair pay. Fair pay is pay for performance. Then, you might think, well, why aren't the employees rewarded for it as well? They often are. So in many of these places, they will get some bonuses, but often their pay should be less volatile than the CEOs. Why? Because, what happens when there's a downturn in the economy? The CEO should suffer because he or she can afford it and they're wealthier, but you don't want employees to suffer.

So employees pay tend to be much more fixed and therefore CEOs pay is more variable, so if there is a high pay ratio, it could just well be that the company's performed extremely well. So certainly when you think about, well, is there something that we care about? Does it matter? Is this a problem? It doesn't seem to be a problem for performance. You might think it's a problem for social equality. Why? Because you might say, I don't care how well the CEOs perform. He could be Bob Iger of Disney who perform extreme well, but got a $66 million paycheck, which was over a thousand times the average worker, and then Abigail Disney came out and said, well, this is obscene.

Well, if that is a problem, there is a solution to that and that is the political process. So we do have a government here which addresses issues such as equality. And as per earlier discussion, what we have is the government is elected by the aggregate citizens of new economy. And, some people are more comfortable with inequality if it's earned fairly and others are not. So some people might vote for high taxes and some people have voted for low taxes, but I do think it should be the government who deals with this inequality issue, while they do have a tool to address it, income tax, where if they don't have a tool to regulate corporate culture and therefore it's not perhaps for the BlackRock or the Vanguards or the Abigail Disney's of this world to impose their preferences, we should look at the preferences of the nation as a whole.

One of the things I know you've written about, Alex, is being open to other people's opinions on stuff that you don't necessarily agree with, or counter opinions to your own. What you just described seems like it might be an unpopular opinion with a lot of people because it is such a hot button issue. What kind of counter arguments do you hear when you talk about that?

It is an unpopular opinion and actually Abigail Disney got really angry at me. So, it was either Forbes or Fortune who interviewed me about this. And, I explained what the evidence was. And then, Abigail Disney went on to do a 10-post Twitter rant, but it was never actually engaging with the evidence. It was an ad hominem attack. So, saying, oh, this is an out of touch professor, oh, he must be a capitalist. Not knowing that my most famous paper is one showing the importance of employee satisfaction.

So there's often resistance to counterarguments. And, there is an interesting study which looks at what happens to somebody's brain when they hear an argument they don't agree with. And, what was found was that part of the brain that lights up is the amygdala and that is the same part of the brain that induces a fight or flight response when you are attacked by a tiger. So people see descending opinions as things like a tiger attack. So often when I give the argument, I don't really see people engaging with sort of the data and the evidence. Often people won't look at that, but they will just say something like, oh, well, this is just one study out of many when it will be a study published in the top peer review journal, or they'll make an ad hominem attack about me being a professor divorced from the real world. When, if I found research that they liked, like my study on employees' satisfaction, they'll latch onto it.

Another one that you've written about, that's kind similar in terms of being a hot button issue is board diversity. Do you think the lack of board diversity is a problem?

Again, I think it depends on what the objective is. So, one objective could be board performance. And so, there is this argument that diverse boards make better decisions, which just makes sense, right? You want to have cognitive diversity, you want to avoid blind spots. Certainly there seems to be some, at least anecdotal evidence of why was there the financial crisis. There was no challenge to the idea that as Chuck Prince says, when the music is playing, you have to keep dancing. I keep writing subprime notes.

Clearly, I'm somebody who should be personally interested in finding a case for diversity as an ethnic minority. I would like there to perhaps be quotas for ethnic minorities for particular selfish reasons. But, when you look at the evidence, the evidence is really mixed on the link between diversity, at least on demographic issues and company performance. So there were McKinsey studies and so on claiming that there's clear evidence, but this is not the case. In fact, embarrassing for me, London Business School recently coauthored a paper, claiming they found clear evidence when in fact they did 90 different regressions. And if you look at the regressions, zero of them were significant.

Yet, they claimed in the executive summary to have found clear evidence. And, because people liked that claim, they never bothered to check the regressions and so they were advertising this result. And so, why might it be that you had that for is that diversity is a really multifaceted issue, right? It doesn't just consider gender and ethnicity. They might be relevant, but are there things like diversity in terms of background, socioeconomic status, political views, and so on? And so, this whole approach of add diversity and stir, let's pick some token minorities like me. When I am just a finance person, would I add cognitive diversity to financial services firm? Perhaps not.

Instead, well, it could be that cognitive diversity comes from other sources. And, it could be that, yes, you are, you should be hiring this woman or this second minority, but are you doing anything to integrate them, to ensure that their views are being held or is it that a board are having some backroom discussions between the old boys club and so on? So when I sort of say these results, again, people will be quite resistant to it, or they will know the research, but bury it. And so, there have been people who've written articles in Fortune magazine and others, which will claim the evidence is unambiguous when I have engaged in conversations with them and they know what the truth is, but they know that the article is much more likely to be read if they're going to claim something that people like.

Now, what is the other reason for you might care about diversity? It could be for societal reasons. It's just like, I don't care about company performance, I just think it is ethical for the makeup of a boardroom of the company to reflect the makeup of the general population. And, that's absolutely fine. So this is why I get so frustrated with people manipulating the business case for diversity, trying to come up with bogus studies, claiming it's going to make me more money. You can do things because they're just the right thing to do, right?

So I don't eat organic meat because of an economic case that it's going to be good for my wallet. It's not, but I think, well, that's something that I just want to do because I think it's more ethical. There are arguments that people might make, which is, well, I think it's just the right thing to do, I'm not going to do it because I'm going to make more money, but I'm going to do it because I would like the diversity of the boardroom to match the diversity of the population. And if so, you can have that position, but say that you are having this position for societal reasons, not for profitability reasons.

The performance part, has that also been an unpopular opinion?

Yes, exactly. So whenever there's thing, which is against the grain, then people will just say, well, this is academic or out of touch, or they will say, well, there's other studies. Well, don't you know all of these other studies. So sometimes when I have these discussions on LinkedIn, which is not often the place to have the most open-minded discussions and somebody will just quote for me research done by another organization. But, there's two issues here.

First, is the research rigorously peer-reviewed? So if you want to get a paper published in the top journal, you have to go through so many things to make sure it's a robust. And number two, sort of a quick test I think to ask yourself, is, would the organization have published the opposite result? So would McKinsey ever come up with a study saying that actually diversity needs the worth performance. They would never do that. So what they want to do is release a study, which boosts their reputation. But if there was an academic finding no relationship between diversity and performance, had they found the opposite relationship, a positive relationship, they would've loved to have published that study, right?

So they're only publishing something which finds no link, because that's what the data says. And, they're held to the sense of integrity. But, would you have published a positive result if you found it? Absolutely. As an academic, you would've.

That's a great test. So you have an excellent TED Talk on what to trust in air quotes, a post truth world. So how do you suggest people find evidence that they can trust?

Yeah, so thanks for asking about that, Cameron. So, why did I give that talk? So when you are invited to give a TED Talk, you often will speak about your own research. It's a great platform to market it. But actually, if researchers selectively listened to you and that people only hear the research if it shows what they'd like to hear, then actually, there's no point speaking about research. I want to speak about how we approach research in general. And so, what I stressed is that we need to look at, is this research peer reviewed, or is this research being vetted by people?

So the peer review process is not perfect. So mistakes get made. Sometimes bad papers get accepted, sometimes good papers get rejected, but it's much better to go with something checked than something which is unchecked. So if you look at some studies, which hadn't gone through peer review, they could make some of the most basic errors. So the London Municipal study on diversity was linking diversity to shareholder returns. They forgot to include dividends in the calculation of shareholder returns, which is a really basic error. That's a key component of shareholder return, but they forgot about it. There were no controls and so forth.

So if you are just latching onto a study because you like the findings, then there's a lot of danger that this study is actually quite flawed. Whereas what happens with peer review? I'm the managing editor of one of these academic journals. What happens is that I will have some of the leading experts in the field, review this anonymously and to tell me, well, whether they've dotted all the I's and crossed the T's and addressed all the alternative explanations.

Another thing that you should do is that if you think that the evidence is really clear on an issue, just try to actively search for evidence in the other direction. So perhaps Google diversity, worse firm performance, or high CEO pay improved firm performance. You might find some studies on the opposite direction. And again, check whether those studies are rigorous because they could be some anti-diversity groups out there, which want to sponsor research finding the opposite. But, if you do find something which is rigorous in the other direction, then that will hopefully moderate your views. And if you don't, then maybe that does suggest that the evidence is mostly in one direction.

I want to come back to your pie growing idea from your book. We talked briefly about the investment implications. How can people separate from people from asset donors, how can people in everyday life use the pie growing mentality to make the world a better place?

I'm really glad that you asked about people then, because often people ask me this about companies and with companies, unless you're the CEO, you don't really control the companies. So pie economics might be irrelevant for the ordinary person working organization. So what is the heart of pie economics? It is how to create value. And, why I think that's so powerful is that anybody can create value, even if you're the most junior person in an organization.

So one thing that I encourage people to ask themselves is, what is in my hand? What do I have in my hand? It could be my resources, my expertise, my time, and how can I use this to benefit other people? So, as an example, my first job was at Morgan Stanley in investment banking. I was right at the bottom. I thought nobody works for me. There's nothing in my hand, I have no influence. But in fact, what I realized was that people did work for me. There was my secretary, there was the IT department and there is perhaps the most abused department in an investment bank, which is the graphics department.

So a graphics department, what you do is, you scribble some slides, you give it to the graphics department, they come up with some PowerPoints. And, often the analysts would shout at them for not doing what they wanted, even though it was the analyst fault for or not having explained it clearly. But, there were times when I got some good work back from the graphics department. I called them up and I say, "Hey, this is Alex. Somebody just did my job. I just wanted to say it was really good. All these three things I asked for were great. And this fourth thing I didn't even ask for, but you did it anyway."

So even as a junior person, in my hand, what I had was my words and my ability to say, thank you. And honestly, I did not do this to be seen to be a goodie goodie, to be seen to be a nice person, I did this honestly, just to say, thank you. But, because I was so junior, because I was right at the bottom, I did not have my own office. Right? I sat in the bullpen, which is where all the analysts sit. And so, other analysts heard me doing this and they started to do it themselves. Now, I'm not going to claim I changed the entire culture of Morgan Stanley, clearly I did not.

But certainly that seventh floor of the offices in Canary Wharf, London, people started to think, oh yeah, can I say thank you to others? And so, I'd say, whatever level you might be an organization, you can actually have a much greater influence than you think you might, because whatever you do might be noticed by others that has a catalytic effect. Similarly, in the pandemic, when some of my friends posted on Instagram or Facebook that they were helping doing shopping for elderly neighbors and we could ourselves say, well, what can we do to help out? One of my friends, who's a lawyer said, oh, he went to his local coffee shop and he advanced purchased a hundred coffees to give them 300 pounds to give them a little liquidity injection.

So all of these things are small things, but if you go with the mindset of how can I actively create value and have a positive impact, that's really different to how people typically approach sustainability. With sustainability, we think about how can we do less harm? How can we cut our carbon emissions and so on? And certainly, that is something which is important. Can I sort of bike to work rather than taking an Uber? But, I think what's often overlooked is that pie growing idea of actively creating value for our words and our actions. And, I think that is something that really can be unlocked.

So I'd like to switch gears if we can, before we run out of time and something that you did a study on, which I thought was really interesting and intriguing was linking the playlist of Spotify to performance of stocks. Can you talk about that and where the idea came from for that study and what you learned?

Absolutely. This might seem a crazy study to do. So, why did I do that? So what I'm interested in is behavioral finance, the idea that markets may not be efficient. We've touched upon market inefficiency in one of your early questions, Cameron. We found that the market is not getting the importance of employee satisfaction, even though the study's been around for 10 years. And so, what that looks at is the market being inefficient in that it does not respond to something that it should.

But, the other way to show inefficiency is to show that the market does respond to something that it should not. So if you have something irrelevant, like investor sentiment and show that the market responds to that, then let's suggest the idea that the market is driven by psychology. Now, one of the most difficult things with investor sentiment is many things that you think might affect the sentiment of the stock market, also have an economic impact. For example, a plane crash or a terrorist attack that will make people really unhappy. But, if this market declines, that could be purely rational because there's an economic effect on it.

So one of my early papers looked at the effect of sports results. So when a country gets knocked out of the World Cup, the market goes down. Why did I look at sports? Because that's a something which doesn't have that strong an economic impact and so that's something which I used to try and show that the market was driven partly by emotions. Now, one of the limitations of that study is that your mood is not just driven by your sports team, right? It might be driven by other things, maybe there's COVID restrictions. Maybe you had an argument with your spouse. Maybe your boss gave you a promotion and so on.

So this is why I looked at the music paper. So the idea here is that when you are happy or unhappy, you tend to reflect this in your decisions, right? So there's a lot of research on what's called emotion congruity. When you are happy, you listen to happy songs, when you're sad, you listen to sad songs. And so, what we used is Spotify streaming data as a reflection, as a proxy for how happy the nation was at the particular time. And, we first validated that. We found that people listened to happier songs on sunnier days, when COVID restrictions at ease and so on. And then, we took this data set and we looked at all the songs listened to, Spotify, has an algorithm, which then measures the happiness of each individual song.

So not surprisingly, Happy by Pharrell Williams is right at the top of the list, some songs by Adele or by Tool and so on are right at the bottom of the list. And, what we were able to do was to link the change in mood as captured by song listing choices, to changes in the stock market.

Wow. And, what did you find?

What we found was that if you look at the equity markets, like when people are listening to happier music, then over the next week, the equity markets went up, but we also wanted to look at it out of sample. So that was a question Ben asked me earlier, we want to make sure it's not just a fluke. So we looked at, also, equity mutual funds. So you found that when there's a happier sentiment, people buy more into equity funds. Why? Because, they're more positive.

And then, we also looked at government bonds as a fortification test. So when you're more optimistic, you should go into equities and move out of bonds and really find lower returns to government bonds as well. And, this was something not just in the US, but I think there was about 40 countries around the world. Again, if you just looked at one country, you might be concerned that we just got lucky in that particular country.

So are we going to see a Spotify hedge fund soon?

Well, the goal of the research was not to find a trading strategy that you can exploit, unlike the best company study. Here, why it might be so difficult to exploit is it involves looking at 40 countries, some of which might be less liquid and so on. But, why we looked at it is not to find a trading strategy, but to show that the market is affected by emotions. And, if we know that the market is inefficient, then that points to other studies like my employee satisfaction study being purely driven primarily by mispricing rather than a missing risk factor and these other explanations.

That's exactly where my mind went, that this music study supports your earlier studies. Really fascinating. Alex, we got two more questions for you. The second to last one, I'm quite excited to ask you, how do you view your role in society as a finance professor?

Thanks for asking that question, Ben. So I have to try to practice what I preach in terms of what I think is in my hand as a finance professor. So I think my purpose as a finance professor is the creation and dissemination of knowledge. And, as professors, we are rewarded instrumentally for research, but only for research. So whether you get tenure, whether you get a promotion, it depends only on publication in academic journals. But, if the purpose of a finance professor is to disseminate knowledge, what matters is not just doing the research, but making sure that research affects practitioners.

So that's why I love doing podcasts like this. It's an honor for me to be invited, to be talking to people who practice this every day as investors, to ensure that this research affects the way in which people allocate capital. I put a lot of emphasis and put a lot of effort into teaching, including I have my own playlist for every class. Why not to be a gimmick, but because I know that when I teach finance, it can be quite scary to some people. I want to have the class in a positive mood, it's more conducive to learning, I'll do things like that. But more than just that, I'll try to make sure that every class is extremely well prepared. It's not just theoretical, it's practical as well. I put a lot of emphasis into teaching, even though it's something which is not explicitly rewarded.

And, also what I try and do is to teach more widely in two ways. First, not just to teach finance, but to teach other softer skills, which I think are going to be important in the workplace. So I do teach things like public speaking, time management, mental and physical wellness. So, why those things? Those are things that I have quite a bit of expertise on. I've done a lot of research on myself. Then, number two, more widely in that I try and teach, not just people at London Business School. Why? It costs, I think, $100,000 to do an MBA at London Business School and some of the people who might be most in need and most benefit from financial education might be the ones who can least afford to come.

So I started a position four years ago at Gresham College. So this is a rather bizarre institution. So it's called college, but you can't get a degree there. All they do is, they offer free lectures to the public like Michael Faraday used to give on science. And so, I've given a four year lecture series of free lectures. And, my current one is on basic financial literacy. So things like the time and value of money, compound versus simple interest, really elementary staff, but these are things which are not covered in high school curricula. So why a lot of people might end up not knowing how to save their money or borrowing from high interest sources is the lack of financial literacy. So that's one way in which I can use my role as a finance professor to disseminate knowledge and disseminate this much more widely than just my LBS students.

Wow. Are those Gresham College lectures available online?

Absolutely. So if you just go to the gresham.ac.uk website, or if you just went to YouTube, Gresham Alex Edmans, I give a four series. The first one was, how business can better serve society, which is most of what we've talked about in the first three quarters of this podcast. The second one was business skills for the 21st century. Those were things such as public speaking, time management and so on. The third was the psychology or finance. Things like sports and of music and the effect on stock markets and behavioral finance. And the final one is the principles of finance, which is basic financial literacy.

Wow. We'll link those in the show notes. So, Alex, how do you define success in your life?

I think success is to have a positive impact on people. So how I define my mission statement is to use rigorous research to influence the practice of business and to inspire other people to fulfill their potential. So the first part is my professional mission. And so, this is why I say rigorous research to influence the practice of business. What I love doing are things like podcasts and so I might turn down an invitation to give an academic talk to a university to do more things like this, or to write an article, let's say, for the Wall Street Journal. I really get a lot of excitement and learn a lot from interacting with practitioners.

Then, the other part to inspire others, to fulfill their potential, again, I think it's really exciting to be a professor in that you have students, the future leaders of this world and if one reason that they might not be able to fulfill their potential is not learning some of the softer skills such as time management and public speaking, those are things that I could pass on. And, these are things that I might do even outside of work.

So when I was a professor at Wharton, then there would be various charities that would come up to me and ask, can you serve as treasurer... obviously as being the finance person... on my charity for homelessness and hunger or whatever. And, certainly homelessness and hunger is really important causes, but, for me, that wasn't at the sweet spot of inspiring. So what I chose to do as my main childhood activity is, I was the head coach for the American Cancer Society, so when people were running marathons or half to raise money from us, I would coach them. And, cancer is sadly something which matters to me because of some family reasons, but also about the whole aspect of trying to get somebody to believe that they can run a half and a full marathon. Not just believe it, but provide some coaching tips to enable to do that, that was something I had a huge amount of excitement doing.

I remember when I would run the same race, I would not just care about my own time, which often you do going into this thing, but I had ingrained in my head, I knew the target times of all of the people I've been coaching. And so, when I finished, what was exciting for me is to see how they hit their target time. And even, if they're not, how they managed to raise thousands of dollars for cancer research, that was something which was really exciting. And, that was part of, I think, success beyond just the standard dimensions of success that you might look at as a professor, things like publications and citations.

Wow. What a wonderful answer. And, this has been an amazing conversation. So Alex, thanks so much for joining us.

Thanks so much, Cameron and Ben. Really enjoyed the conversation. Thank you so much for inviting me.