Investors have long debated the performance impact when including environment, social and governance factors. While ESG purists might be perfectly comfortable potentially sacrificing basis points, no hard evidence exists to suggest ESG factors compromise returns. And certainly no one can guarantee that any investment choice will have a positive — or negative — outcome in the long term. Yet the Department of Labor appears to think otherwise.
On April 23, the DOL released Field Assistance Bulletin No. 2018-01 that aimed to offer guidance to plan fiduciaries about how ESG investing may and may not be considered in the investment process.
This follows guidance that was published by the DOL in 2015, which seemed to open the door to plan sponsors considering ESG factors. This guidance cited mounting academic evidence and the materiality of some factors in support of the DOL's view that ESG could be additive to the investment process.
The new guidance is being seen by some as an attempt to dissuade the use of ESG factors — which seems curious at a time when more investors are including material ESG factors in their analysis.
At CFA Institute, we are helping to encourage the use of ESG data in the investment process, as understanding ESG and incorporating it into a holistic process is part of the curriculum that more than 200,000 people study every year in order to earn a Chartered Financial Analyst designation.
So what is going on here? What did the DOL say and why does it matter?
In its bulletin, the DOL cautioned that, "The department has a similarly long-standing position that ERISA fiduciaries may not sacrifice investment returns or assume greater investment risks as a means of promoting collateral social policy goals."
Further, the bulletin states: "Fiduciaries must not too readily treat ESG factors as economically relevant to the particular investment choices at issue when making a decision. It does not ineluctably follow from the fact that an investment promotes ESG factors, or that it arguably promotes positive general market trends or industry growth, that the investment is a prudent choice for retirement or other investors."
This new guidance seems to suggest the Labor Department would question a fiduciary's adoption of an ESG-reliant strategy for a client's retirement funds, presumably on the basis that it might negatively impact future returns.
In essence, the DOL rule warns against adding an ESG option or a "values fund" to an employer's defined contribution plan. Baked into this wording is an assumption that any ESG fund is automatically a negative screening or socially responsible investment fund, and that such a fund is, by definition, one that will underperform.
There appears to be some definitional confusion and assumptions around ESG made here, which we can clarify.
ESG investing is broader than SRI, which is normally associated with a negative screen of companies that don't comport with a certain set of an investors' "values." For example, an SRI investment might screen out alcohol, tobacco, weapons or some company or industry an investor cohort finds objectionable.
However, the CFA Institute looks at ESG as more than just a negative screen. ESG analysis has moved beyond to a broader process in which analysts and fund managers are looking to pinpoint material ESG factors that can present both risk and opportunity.
a) A survey of our global membership shows most investors integrate ESG into the investment process, although some do incorporate a negative screen.
b) Those including ESG in the investment process are primarily doing so to evaluate risk. It is highly presumptuous to assume ESG analysis automatically leads to more investment risk. The current state of ESG analysis is primarily about mitigating risks through careful concerned analysis.
c) If a client/beneficiary wishes to accept the possibility of lower returns to achieve some non-financial outcome — shouldn't they have that right? There might be trade-offs some investors will be willing to accept to arrive at outcomes that are not purely financial in nature.
The most prominent example these days is related to climate change. Many investors are willing to accept the risk of potential lower returns (not a certainty of lower returns) to invest in ways that help to mitigate the effects of climate change and bequeath a more livable planet to future generations. And in this particular example, assuming lower returns for climate change investments seems dubious at best, as over the long-term the financial consequences of doing nothing about climate change will surely have a negative impact on nearly all portfolios.
Should ESG be mandatory or prohibited? There is a more prudent course.
Investors are increasingly aware of how their investments impact the world in which they live and are seeking to make more impact with their decisions.
The European Parliament is considering legislation that would call for mandatory integration of financially material ESG factors for all actors across the investment chain, and the incorporation of the cost of non-action on climate, environmental and other issues in the risk management and due diligence of company boards and public authorities. This moves the EU in the opposite direction of the DOL.
A middle ground is possible. At a minimum, fiduciaries should be able to incorporate "values" when a credible case can be made that it affects "value." Examples abound: best-in-class corporate governance; ESG turnaround stories; custom screens that minimize tracking error Imposing "supravalue" factors should be the domain of asset owners and of fiduciaries only when acting at the behest of their clients/beneficiaries.
We do not believe ESG integration should be mandatory. But we do consider it to be good analysis, and the market already is figuring out that including ESG factors leads to more robust analysis and more informed decision-making.
Investors also need to take responsibility for their investments and ask themselves what financial trade-offs they are willing to accept for a desired outcome. There is no guarantee of investment performance in the long term. But investors, and their fiduciaries, should have conversations about the costs they might incur to include their "values."
How many basis points would you be willing to sacrifice for the values you hold dear? If that number is more than zero, those conversations need to begin.