ESG Portfolios:An Evolving Effort to Improve Outcomes
Socially responsible investing has come a long way. In the 1970’s, Milton Friedman argued that social responsibility negatively impacts a firm’s financial performance and that government regulation damages the macro economy. For decades, it was taken as a given that socially- or ethically-directed investments should underperform the broad market, and so investors were given a false choice: do the right thing or make money.
In the early 2000’s, research began to indicate that making money and being socially responsible need not be mutually exclusive. To the contrary, it was demonstrated that social responsibility can actually improve both firm performance and investment returns. As a result, investment firms, fund managers, and the like began to offer “socially screened” investment choices, whereby investors could purchase those slices of the market that had the best social or environmental scores and impact.
Today, the landscape has shifted even further. Instead of thinking about social responsibility as a screen or overlay on top of the traditional investment process, it is increasingly being argued that investors should make the analysis of social and environmental factors a part of the investment process itself. In other words, just as an investor might consider financial metrics like profit margins or growth rates, that same investor should also consider things like a firm’s impact on the environment, its treatment of its workers, and the diversity and gender balance of its leadership team. Really, the argument is straightforward: A company’s long-term financial success is not divorced from its impact on society and the world around it. A sustainable business, one that is likely to deliver profits well into the future, is, by definition, one that treats its employees and customers well, one that takes care of its environment and the resources it needs to survive, and one that is smartly and fairly governed.
Many terms and phrases have popped up to describe what socially responsible investing means. The challenge is that it means different things to different people, and there is no one, true definition of social responsibility. However, within the business and investing world, consensus has generally coalesced around the acronym, ESG (Environmental, Social, and Governance). While this acronym is imperfect, it gets at the major pillars of socially responsible investing.
Environmental considerations include carbon emissions, water scarcity, energy use, the environmental impact of a company’s supply chain, and the environmental impact of a company’s products. Social considerations include workplace safety, workplace diversity, data privacy and security, human capital development, and product quality and safety. Governance considerations include board structure and diversity, corruption and supply chain management, accounting policies and controls, and executive compensation. The argument, again, is that companies excelling in these areas should succeed over the long term, because they are built upon stronger, more sustainable, foundations that allow for a diversity of thought and opinion.
At Deighan, we’ve long taken ESG considerations into account when selecting investments for client portfolios. This isn’t to say that every stock on our buy list would meet criteria for inclusion on a socially-screened investment list. However, where practicable, we include ESG factors in our analysis, and we reject stocks that are egregious ESG offenders.
In addition, we recently developed a series of fund-based ESG portfolio strategies. Using a combination of mutual funds and low-cost exchange-traded funds (ETFs), our ESG portfolios are designed to replicate, as closely as possible, our regular investment portfolios while incorporating additional screens for environmental, social, and governance factors. As with our regular portfolios, our ESG portfolios are well diversified across asset classes and geographies. We’ve taken care to select managers who have dedicated ESG strategies, as well as managers who have historically managed their funds in a way that aligns with our definition of social responsibility.
Our view is that a good investment process accounts for ESG factors, and we expect the industry to continue its shift in this direction. If you are interested in learning more about our ESG portfolios or how we incorporate social responsibility into our investment process, simply give us a call or send us an email. We’re always happy to hear from you.
A Further Note:
On June 23rd, the Department of Labor’s Employee Benefits Security Administration (EBSA) proposed a rule that would significantly limit the ability of fiduciaries to offer ESG funds in employer-sponsored retirement plans covered by the Employee Retirement Income Security Act of 1974 (ERISA). Under previous DOL guidance, an ESG fund could be offered so long as it was found to be substantially similar to other possible investments in terms of fees and risk-adjusted returns. The idea was that ESG funds have the potential to provide additional, non-pecuniary benefits (i.e. social and environmental betterment) and these benefits would win the tie-breaker in an “all-things-equal” test. A responsible fiduciary exercising due diligence, taking appropriate care, and acting in good faith could find reason to include well-managed ESG funds under previous guidance and would have been allowed to do so.
The new regulation seeks to tighten the all-things-equal standard. Under the proposed rule, an ESG fund could only be offered if it wouldn’t require the plan to forego offering non-ESG choices. In addition, fiduciaries would only be allowed to use “objective” risk and return measures when selecting offerings, and, under the rule, the EBSA does not consider non-pecuniary benefits (read “ESG” benefits as the EBSA defines them) to be objective. Lastly, an ESG fund would not be allowed to be designated as a Qualified Default Investment Alternative (QDIA) or a component of a QDIA, no matter how good that particular ESG fund might be. The rule would also require additional, specific documentation in those “rare circumstances” when an ESG fund might be chosen over an otherwise economically indistinguishable alternative investment. This additional documentation, which would come with added expense and complexity, would likely act as a deterrent for fiduciaries.
On its face, the EBSA makes a rational case for the proposed rule, arguing that fiduciaries should not attempt to promote social causes or put non-pecuniary interests over the pecuniary interests of plan participants. Few people could argue with this prema facie line of reasoning. However, looking deeper, to agree with this argument is to ignore decades of research demonstrating that ESG factors can add monetary value to investment portfolios and are more than just non-pecuniary, fringe benefits. The proposed rule ignores the significant trend, discussed earlier in this blog post, toward including ESG factors as part of the regular investment research process, and, flatly, it ignores the industry’s current and best thinking on the subject. In short, the proposed rule is predicated on an outdated, Friedman-esque understanding of ESG investing that views ESG factors as a financial burden rather than a financial benefit. The rule is regressive in its reasoning and its intent, and, unfortunately, it is likely to limit employer retirement plan choices and harm investors rather than protect participants from any great danger.