An increasing number of investors want their portfolios not only to do well, but also to do good. But, at least according to the U.S. Labor Department, retirement investors with such goals need to be saved from themselves.
“Environmental, social and governance” criteria, usually abbreviated ESG, represent a set of standards rapidly gaining acceptance by investors as a tool for screening potential investments. Environmental standards relate to a company’s track record as a steward of the natural world and its resources; social criteria deal with a company’s actions toward its employees, suppliers, customers and community; and governance concerns the company’s leadership, executive pay and internal structure.
Mutual funds and exchange-traded funds that fall under the ESG umbrella have taken off recently, especially since the 2016 presidential election. While socially responsible mutual funds have existed in some form for more than 40 years, the highly charged political environment gave their profile a significant boost, especially among concerned individual investors. Morningstar Inc. reported that assets invested in ESG funds grew to $95 billion overall by the end of 2017, up nearly 60 percent from 2016.
At Palisades Hudson, we occasionally use ESG funds in client portfolios if clients request it. Yet many, if not all, companies have traits to which certain investors might object, raising the question of where to draw the line. We typically recommend that clients who are interested in supporting conservation or social change instead invest in a diversified portfolio and direct a portion of the returns to supporting organizations working toward the goals they value.
Even so, we have no particular objections to ESG funds across the board. But the Labor Department might.
In April, the Labor Department issued a notice warning that companies “must not too readily treat ESG factors as economically relevant” when choosing which investments to offer in a retirement plan. The department went on to say that it cannot be assumed if “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.”
In other words, employers who offer ESG funds in their retirement plans may be violating their fiduciary responsibility to their employees. According to the Employee Retirement Income Security Act, often abbreviated ERISA, employers that offer retirement plans such as 401(k)s must act in the best interests of plan participants. The Labor Department notice does not, at least for now, outright forbid companies from including any ESG fund in their retirement plan’s investment menu. However, based on this notice, if such a fund doesn’t perform well, employers might be exposed to compliance complications they would rather avoid. If the Labor Department aggressively pursues such cases, it may well discourage employers from offering such funds in the first place. At a minimum, plan administrators may feel that they need to more thoroughly document the financial reasons for offering such a fund, and as a result they may find it easier not to bother.
The Labor Department’s stance strikes me as troublesome. If an employer offered ESG funds exclusively, I could easily view it as a problem, but it is hard to see how including one or two in a wider menu of investments violates an employer’s fiduciary responsibility, especially as investor demand for these funds continues to grow. When my clients don’t like the funds offered in their 401(k) or want to invest in an investment strategy that the plan does not currently offer, I often tell them to suggest new funds to their employers. This approach is perfectly appropriate and can often lead to positive changes.
If employees want an ESG fund and ask employers for them, it is hard to argue that providing one would violate the employer’s fiduciary duty. There are many asset classes or sectors that particular investors or asset managers may prefer to avoid, for a variety of reasons. At Palisades Hudson, we have written before about our concerns about the use of long-term bond funds or employees who feel encouraged to hold too-large positions of their company’s own stock. But just because these are potentially bad choices for a particular investor doesn’t mean a company is irresponsible to offer them.
The Labor Department cites ESG funds’ poor returns, but this reasoning fails the smell test. Some ESG fund advocates argue their returns are as good as comparable funds or, in some cases, better. A 2015 study in the Journal of Sustainable Finance & Investment examined about 2,200 studies and found that in 90 percent of cases, there was no negative correlation between concern for social factors and financial performance. The Wall Street Journal recently reported that ESG ETFs outperformed the broader market in the 12 months ending in March 2018. While I’m skeptical of claims that ESG funds as a group will consistently outperform more diversified strategies over the long term, I would expect them to outperform at times, similar to other funds that pursue a strategy of holding a concentrated portfolio. ESG strategies are still relatively new, and at this point it is not a self-evident fact that ESG fund returns are worse across the board.
The Labor Department may be attempting to fix a problem that largely does not exist. A 2017 study from US SIF (formerly known as the Social Investment Forum) found that only 14 percent of employer plans offered at least one ESG fund; a study from Plan Sponsor Council of America put the figure even lower, at 2.4 percent. In addition, the Labor Department discouraged plans from designating ESG funds as the default option for participants who have not selected an investment allocation. But I would agree with Meg Voorhes, the director of research for US SIF, who told Investment News, “I don’t think anyone was thinking of using ESG for the QDIA [qualified default investment alternative].”
Fiona Reynolds, the chief executive officer of Principles for Responsible Investment, diplomatically said, “It is difficult to understand the reasoning” behind the Labor Department notice. The restriction on ESG funds seems more like retaliation than a sincere effort to protect investors. If nothing else, adding additional restrictions on retirement plans is not a very consistent move from an administration that has vowed to ax as many regulations as possible.
It is important to make sure that employers are offering reasonable menus of investment choices to their employees, but the entire point of self-directed retirement accounts is to give individual investors a level of control over their portfolios. Even if I do not recommend ESG funds for my own clients, this doesn’t mean I think they are so dangerous employers should be barred from offering them at all.