Recent steps by the US Department of Labor have highlighted the curious rationale for environmental, social and governance (ESG) investment.
In July, more than 700 commenters wrote in condemnation of a new rule proposed by DOL that would limit the ability of most employees to make retirement plans to select investments based on ESG factors. But the DOL’s move is well-established, and it’s not surprising that many trivial criticisms, blaming the DOL for everything from perpetuating racism to political interference, have come from active fund managers.
The truth is, ESG is such a broad and bizarre idea that without strong credible standards, it risks becoming a convenient excuse for the same fund managers to lower their benchmarks while charging higher fees.
ESG proponents often turn a win-win narrative, where corporate behavior is combined with certain values and practices that lead to better financial results and investment effectiveness. Yet, like all complexities, the reality is not so clear: difficult decisions are often made while balancing the goals of financial gain and social responsibility.
Psychologist Philip Tetlock speaks of an uncomfortable situation like this “forbidden tradeoff”: Whether we admit it or not, socially responsible investment choices will sometimes come at the expense of financial returns. Whether it is appropriate for plan sponsors to try to make those tradeoffs on behalf of their beneficiaries in the final stages of DOL’s intervention.
Outcome: In the coming months, ESG integration exercises could become a new battleground in the growing tsunami of cases of breach of trust against the Employees Retirement Income Protection Act (ERISA).
The argument that ESG factors lead to long-term performance outcomes is much harder than we imagined. Academics have found a surprisingly low correlation between ESG ratings across providers. In other words, experts cannot agree that any company has strong ESG certification in the first place. Part of the problem is that the ESG umbrella encompasses many different things, the symptoms of which are constantly changing.
The so-called sin stocks of tobacco and defense যা which incidentally defeated the broader market in the long run ছিল were the real ESG castways. Then for most of the past decade, ESG has become almost synonymous with tackling climate change and measuring carbon footprint. Today, companies and investors are rushing to compile metrics and scorecards on diversity and inclusion, which has quickly moved to the top of the ESG program.
Let us assume for a moment that the problem of this measurement and the existence of prohibited tradeoffs, that ESG exposures can be accurately identified and have a positive impact on corporate financial performance. A second and more difficult question then arises: how much of this information has already been included in the value of the asset?
If ESG certificates are already valued in stocks, the best investment strategy may actually be to buy from the worst performers on the ESG scale. To see why, consider that private equity firms do not look for the best managed firms for acquisitions. Rather, they often target companies with serious operational problems because the biggest potential value improvement is when those companies improve.
Similarly, today’s ESG “lagguards” may face increasing pressure to rearrange and improve themselves over time. If improving ESG certifications actually achieves better financial results, these lagguards could prove to be the best investment at today’s prices. This is another reason why the investment structure around strong ESG performance could have adverse financial consequences.
Move fast in the long run যা which economists quickly point out never comes এবং and assume that there is no further adaptation, and that firms have reached their stable ESG position. Even then, we would still expect companies with weak ESG credentials to outperform the average. Financial theory says that in order to bear the financial risk (and social stigma) of holding these firms, investors will need higher returns. This is the opposite of the argument that taking an ESG can lower a firm’s discount rate: the lower the capital cost of the firm, the lower the reward for its capital providers.
In short, the DOL should not bow to criticism of vested interests just to do its job and try to ensure the financial security it needs to retire comfortably.
If ESG proponents are so confident about the impact of ESG’s win-win on performance, they should have no hesitation with a regulatory requirement that this relationship is actually true.
If you liked this post, be sure to subscribe Entrepreneurial investors.
All posts are the author’s opinion. As such, they should not be construed as investment advice, or the opinions expressed must not reflect the views of the CFA Institute or the author’s employer.
Image Credit: © Getty Images / Abstract Aerial Art
Professional education for CFA Institute members
Members of the CFA Institute have the ability to earn self-assessment and self-reporting professional education (PL) credit, including content Entrepreneurial investors. Members can easily record credit using their online PL tracker.