If ESG Enhances Profits, Then Why All The Fuss?

If ESG Enhances Profits, Then Why All The Fuss?

The Department of Labor finalized a rule last month that, as the Wall Street Journal editorial page noted, should not be controversial. The rule states that private pensions cannot let ancillary issues distract them from their primary mission of securing their beneficiaries’ retirement.  Failure to achieve this mission jeopardizes the financial security for millions of Americans.

Providing a secure retirement is not just the primary social responsibility of pension funds. As Supreme Court Justice Benjamin Cardozo noted, it is also their legal responsibility under the Employee Retirement Income Security Act of 1974 (ERISA). The recent clarification simply emphasized these common-sense notions in light of the growth in Environmental, Social, and Governance (ESG) investing.

Proponents of ESG investing claim that by prioritizing ESG considerations, fund managers can promote better financial returns and improve social outcomes – the quintessential win-win. Due to these claims, there is growing pressure for private pensions, which invest $10.7 trillion on behalf of nearly 140 million Americans, to prioritize ESG considerations.

If the proponents of ESG investing are correct, then companies complying with ESG criteria will grow faster than companies that do not. And, there is every reason to believe that this relationship will sometimes hold. Consistent with this investment theory, there is evidence that many ESG funds are outperforming traditional funds in recent years.

However, pension fund managers do not need any new investment mantras to benefit from these trends. Pension funds that simply focus on maximizing returns will invest in companies with superior fundamentals, regardless of the reason. Therefore, ESG investment criteria are only necessary if investment resources are allocated based on non-financial reasons. There are many reasons to be skeptical that ESG investments based on non-financial criteria will outperform the market over the long-term.

Substantiating this skepticism, there is no evidence that ESG funds outperform investment benchmarks (like a passive S&P 500 index fund) over the long-term. The major pension funds in California (CalPERS and CalSTRS), which are ESG leaders but have also been significantly underperforming their investment return targets, exemplify this problem.

There are also many practical concerns with ESG investing that simply make it inappropriate for large pension funds. It is important to note upfront that these concerns apply to pension funds, not individual investors. As SEC Commissioner Hester Peirce noted in a 2018 speech

“problems [with ESG] arise when those making the investment decisions are doing so on behalf of others who do not share their ESG objectives. This problem is most acute when the individual cannot easily exit the relationship. For example, pension beneficiaries often must remain invested with the pension to receive their benefits. When a pension fund manager is making the decision to pursue her moral goals at the risk of financial return, the manager is putting other people’s retirements at risk.”

First, ESG funds have, on average, higher costs and bear larger risks. They tend to be riskier because they allocate a larger share of their portfolios toward their top holdings on average than broad-based investment funds. Less investment diversity inflates performance if these stocks are rising, but is devastating when their performance lags.

Second, there is a wide divergence in ESG strategies. Some funds simply refuse to invest in certain industries (passive ESG investing). Others will only invest in companies that meet specified ESG criteria (pro-active ESG investing). Often, investments into pro-active ESG funds are inappropriately based on the results of passive ESG funds creating unknown risks for pension beneficiaries.

Third, ESG is a vague concept so one organization’s ESG star is another’s laggard. Take Amazon as an example. The company recently raised its minimum wage to $15 an hour, which is a typical goal of ESG proponents. However, Amazon is also widely criticized for the company’s impact on the environment. Due to these realities, an ESG fund that emphasizes governance could rate Amazon highly whereas an ESG fund that emphasizes the impact from a company’s operations on the environment could rate the company poorly. Under these conditions, it is unclear how a pension fund manager should determine whether Amazon is ESG compliant or not.

Fourth, many of the risks associated with ESG funds are typically hidden from pensioners. Take investments in alternative energy ESG funds. These funds are assuming investment risks that these technologies will flourish, and that fossil fuel consumption will decline. Perhaps this scenario will occur, but perhaps not. These risks are rarely expressed to plan participants. Importantly, investment managers assuming these risks in pursuit of non-financial goals are violating their fiduciary responsibility – private pension fund managers are not acting “solely in the interest” of the plan beneficiaries as ERISA requires.

Fifth, many ESG funds do not actually execute on their stated strategy. For instance, a 2019 Wall Street Journal article found that, compared to non-ESG funds, the portfolios of several ESG funds held a larger share of bonds issued by Saudi Arabia – a country with large oil interests and a terrible human rights track record.

Faithfully executing their fiduciary duty is the primary social responsibility of private pension managers. The bedrock foundation of this responsibility is achieving the best risk-adjusted return for plan participants. The proposed rule clarified this obligation and, in so doing, helps ensure that pensioners’ hard-earned retirements are not unnecessarily jeopardized. This is, after all, their core social responsibility.

I am a Senior Fellow in Business and Economics at the Pacific Research Institute and the Director of PRI’s Center for Medical Economics and Innovation. My research explores the connection between macroeconomic policies and economic outcomes, with a focus on the health care and energy industries. I have over 25 years of experience advising Fortune 500 companies, medium and small businesses, and trade associations. I received my Ph.D. in economics from George Mason University.

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Nothing contained in this blog is to be construed as necessarily reflecting the views of the Pacific Research Institute or as an attempt to thwart or aid the passage of any legislation.