Fiduciaries need more to drive selections than a wish to change the world.
By John Keefe Investment Focus Published in PLANSPONSOR APRIL/MAY 2019
Investing to achieve environmental and social goals gets numerous headlines these days, with a particular focus on fossil fuels, carbon footprints, and climate change. The practice goes far back, however, to the founders of the Methodist Church in the 18th century, Quakers in the 19th, and the first socially conscious mutual fund in 1928. A generation ago, a socially responsible investing (SRI) movement avoided certain investments altogether, such as companies selling tobacco or firearms, or doing business in countries with deficient human rights records.
SRI investment has evolved from exclusion into investing with a more holistic view of companies’ environmental, social and governance (ESG) behaviors. But there are conflicts between investing for social goals or sustainability and sponsors’ by-the-numbers fiduciary responsibilities under the Employee Retirement Income Security Act (ERISA). “In a retirement plan context, wanting to change the world is not a fiduciary consideration,” says Alex Bernhardt, U.S. responsible investment leader for Mercer Investments in Seattle. “But adding an ESG plan option because you think it’s financially competitive is a defensible decision.”
One of the knocks on ESG investing has been that its choices lead to subpar performance. That question has been extensively studied, though, and many researchers have concluded that sustainability does not penalize portfolio results. MSCI made a comparison, based on ESG indexes it had compiled, of the value of a hypothetical $100 invested for 10 years in the broad U.S. market and in its selection of ESG leaders, as well as in the world’s developed equity markets and in their respective ESG leaders. In both cases, performance of full markets vs. ESG portfolios is virtually indistinguishable—for the world markets, both terminal values in early 2019 are $341, while the U.S. ESG leaders generated $466 over 10 years, just below the $476 for the full market.
The evolution to ESG includes a broader research process into companies’ businesses. “You’re going to look at the financial returns of a company and not pay any attention to the governance?” says Rob Thomas. His firm, Social (K), in Springfield, Massachusetts, is a consultant and “matchmaker” of sorts in the industry bringing ESG-screened investment options to DC retirement plans and advisers for 10 years-plus. “You can come up with examples all day long for the value of the ‘E’ and the ‘S.’ It just makes sense that more due diligence will lead to better returns.” (My italics!)
“We state that we are growing wealth responsibly, not that we are creating a more promising future for the world,” says Joe Sinha, chief marketing officer at Parnassus Investments, a $26 billion investment manager, located in San Francisco, that has followed ESG criteria since 1984. “We were founded on the belief that you can invest on your values and still beat the stock market. That calls for a 360-degree, holistic view of enterprise values.” About 20% of the firm’s assets are invested for retirement plans, but, Sinha points out, “Many of our clients are with us for our fundamental investing and not for the ESG.”
Natixis Investment Managers, in Boston, introduced an ESG-themed target-date-fund (TDF) series in 2017. “ESG is part of every decision in the TDF range,” explains Ed Farrington, head of retirement strategies. “To construct a diversified glide path over a 60-year time frame, we take a broad view of ESG, covering large and small equities as well as fixed income.” Natixis affiliates manage the various sleeves, and passive strategies are applied in areas hard to access such as the emerging markets.
Even when portfolios are tied to market indexes, managers can act on ESG principles. State Street Global Advisors (SSgA) manages roughly $179 billion in funds, but as an index manager the firm is often beholden to the methodology of core indexes, sticking to the companies included and their portfolio weightings. But even when portfolios are tied to market indexes, managers can act on ESG principles. “We’re able to do the ‘G,’” says Greg Porteous, head of defined contribution intermediary strategy, in Boston. “We spend a lot of time on governance and withhold our votes where companies aren’t assembling diverse boards of directors.”
In evaluating the results of ESG managers, “we do not make any concessions,” says Bernhardt. “An ESG-themed fund has to perform well against the broader universe in which it operates, so we don’t compare ESG funds against ESG indices. If they don’t stack up on that basis, then it’s not a prudent decision.” Mercer has had a formal ESG effort for 15 years and ratings on managers since 2008. “Now we have over 4,600 funds rated, and about 20% earn a rating of 1 or 2 on a 4-point scale.”
For all the attention paid to diversity, climate change and other potential avenues for corporate responsibility, ESG investing has been slow to take off in DC plans. In its How America Saves 2018 survey, Vanguard Group reported that while 20% of participants are offered a sustainable option—mostly at large plans—just 3% of that group make the choice.
This low share is largely due to the structure of the DC market and the dominance of TDFs, which receive the lion’s share of contributions. However, consultants and asset managers envision several different catalysts for broader ESG investing in the coming five to 10 years.
At the opposite end of the spectrum from TDFs are managed accounts, which Porteous says could be fashioned into ESG defaults. “Advisers could build portfolios in managed accounts and make them available to participants oriented toward ESG.”
“The adoption [of ESG] in DC plans will be most successful where those factors are considered alongside any others that have economic consequences,” reiterates Jason Shapiro of Willis Towers Watson, in New York. “The better that investment managers can display that, the less controversial the idea will become.”
Sinha agrees that sustainable investment choices have to pull their weight and stresses, “There can’t be any handicapping for the ESG fund. It can’t underperform other options in the plan, and it must have normal fees.”
But Farrington sees participants as the prime movers. “By 2025, 75% of American workers will be Millennials. They demand transparency and want to know how companies behave and that someone is asking those questions. They will pressure the employers, who will see that ESG investing is aligned with their fiduciary duty and not in conflict with it.”