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It’s been the craze for several years now as the generational change in demographics highlights new marketing trends, but it has come under fire lately from several different directions. What is “ESG” investing, really?
The problem is no one knows. Or maybe everyone knows. And they all believe (very strongly, by the way) it’s something different.
“One issue with ESG investing, like many investing strategies, is that there is no agreement on what it is in theory or in practice,” says Albert Feuer, Principal at the Law Offices of Albert Feuer in Forest Hills, New York. “There is not even agreement about what terms ESG investing refers to. Some refer to environmental, social and governance factors. Others refer to environmental, stakeholder, and governance factors. Whichever definition is used and whichever individual factors are selected or emphasized, ESG investing is nothing more than using such factors to help determine whether to acquire, dispose of, or how to exercise ownership rights in an interest in the enterprise. There is also no agreement on how such factors are to be used by investors. Focusing on such factors, as on any set of investing factors, may be intended solely to improve financial returns, such as by better valuing their effects on business performance.”
On the other hand, like many investment strategies, the truth lies within the eyes of the beholder. Just as some investors prefer “Growth” investing over “Value” investing, and others prefer “Value” over “Growth,” so, too, may some investors see a role for ESG (however they define it) while others do not.
“ESG is not an overall strategy but can be used as a factor when developing an investment strategy,” says David Blaylock, Head of Financial Planning for Origin in Dallas-Fort Worth. “For example, a person’s investment strategy may be to reduce risk, and factoring in risks to businesses on the ESG front may help to achieve the goal of the investment strategy. To be labeled as an investment strategy, someone would expect to see the impact in the areas mentioned. As it stands today, we do not see how this type of investing relates (i.e., ESG) to anything beyond a preference.”
“Better evaluating the effects of climate change on different enterprises would be another example,” says Feuer. “In such case, ESG investing, like any strategy, may be measured by simply looking at financial returns, risk-adjusted or absolute, over desired time frames. Focusing on such factors may also be intended to, in part, encourage better performance of enterprises in terms of those factors. This may (but need not be) at the expense of financial returns. In such a case, it is appropriate to ask whether those ESG performance measures are good measures of the reason for considering such measures. For example, if the aim is to improve worker compensation, is the measure confined to employee compensation or does it apply to all the workers associated with the enterprise, such as the enterprise’s independent contractors or business associates.”
Making matters worse is the increased use of ESG as a moral measure. This allows the discipline to fall within the realm of partisan grandstanding.
“One of the many concerns preventing widespread ESG adoption within defined contribution plans is ESG’s overtly politicized nature, as evidenced by the whiplash-inducing changes in regulatory guidance from the DOL every time a new political party takes control of the White House,” says Christopher Jarmush, Area Sr.Vice President and Director of Defined Contribution at Gallagher Fiduciary Advisors, LLC in Washington, DC. “Plan committees should tread carefully as any direct action regarding ESG in their plan line-ups will likely lead to some cohort of participants being upset, particularly in this highly polarized (and litigious) environment.”
In many ways, when “ESG” was more narrowly defined as “SRI” (“Socially Responsible Investing”) in the 1980s, it was easier to isolate those investments (and the nature of their returns) because SRI restrictions tended to be quite specific.
“The change in vocabulary from ‘socially conscious’ to ESG has watered down the concept to the point where it’s almost meaningless,” says Peter Nerone, Compliance Officer at MM Ascend Life Investor Services, LLC in Cincinnati. “When some funds would classify themselves as ‘socially conscious,’ they stated clearly in the fund objectives the types of companies they would invest in and the types they would avoid. There is no such clarity with an ESG rating.”
Within the investment industry, those who question ESG often ignore the politics and focus squarely on the numbers.
“Opponents of ESG often point to the minuscule differences in portfolio holdings (compared to core index fund counterparts) while highlighting the massive differences in fees,” says Jarmush. “The claim is that ESG funds are nothing more than paint-by-number portfolios being sold at Picasso prices. As fads often go, this has been a boom for Wall Street and a bust for Main Street.”
Recently, several media reports have highlighted how funds claiming to concentrate on “ESG” factors have significantly underperformed during the down market. This underperformance may be more spurious than the articles’ headlines make them appear. The same, by the way, can be said of these funds’ apparent overperformance.
“Short-term investment performance of any market sector is fundamentally meaningless,” says Michael Edesess, Managing Partner/Special Advisor at M1KLLC in Hong Kong. “Underperformance of ESG funds could be a follow-on to their previous overperformance that was due to money pouring into them (I hesitate to use the phrase ‘reversion to the mean’ because it is so misused and misunderstood, but in this case, it may help in the explanation).”
Yet, even short-term underperformance reveals a slight crack in the wall of ESG. Advocates of this approach have often claimed that investing in ESG factors will not have a negative pecuniary impact. (Those in the know will recall that the Trump DOL said retirement plan fiduciaries must always place pecuniary factors as the highest priority when selecting plan investments.)
“It is obvious that ESG funds would lag this year while they significantly outperformed in 2020 because the Energy sector is not represented in most ESG strategies,” says Brendan Sheehan, Managing Director at Waymark Wealth Management in Marlborough, Massachusetts. “Thus, in 2020, when Energy was down -33.7% compared to a +18.4% for the overall market, ESG strategies significantly outperformed because many did not include a drag from energy stocks. Conversely, as of June 30, 2022, the Energy sector was up +31.8% compared to a -20% for the overall market. ESG funds do not benefit from the inclusion of this outperforming sector.”
The potential for significant underperformance by omitting strong sectors has been the traditional knock on SRI funds over the decades. It would be silly to assume ESG funds wouldn’t suffer from the same malady.
“ESG funds have been lagging this year because they intentionally avoid fossil fuels and commodities which perform well when inflation is high and have high exposure to growth stocks such as tech, which perform poorly when inflation is high,” says Jeremy Bohne, Financial Advisor and Founder of Paceline Wealth Management, LLC in Boston. “In such an environment, strategies that invest only in companies that are corporate governance leaders in their respective industry may produce very different results than those that eliminate entire sectors of the economy based upon what they do.”
You begin to see how ESG investing requires a level of sophistication not commonly found in the typical employee.
“All 401(k) participants are savers; few are savvy investors,” says Jack Towarnicky, Of Counsel at Koehler Fitzgerald, LLC in Powell, Ohio. “401(k) participants are best characterized by their diversity: ages 18-100+; new hires to 50+ years of tenure; high school dropouts to those with Ph.D. or professional degrees (JD, MBA); individuals making their first contribution to those with a lifetime of savings. One other obvious feature, confirmed by the S&P Global Financial Literacy Survey and the TIAA Institute-GFLEC Personal Finance Index, is participants’ unpreparedness to be investors.”
Here’s where the successful marketing effort regarding ESG may harm naïve retirement savers.
The ESG phenomenon may simply be “investors acknowledging that they feel good because their investment is improving the world we live in,” says Ron Surz, Co-Host at Baby Boomer Investing Show in San Clemente, California. “Good investments should not require advocates. ESG is a play on people’s desire to do good.”
If this is the case and today’s “feel good” investment may lead to tomorrow’s “feel bad” retirement, what can today’s 401(k) participants do to teach themselves how to avoid succumbing to the lure of “feel good” investments?
“How can 401(k) participants ‘train’ themselves?” asks Towarnicky. “That’s gallows humor, right? The answer is most don’t, and most won’t. Plan investment fiduciaries know this and take this into account when constructing 401(k) investment lineups. And participants know this too! Increasingly, 401(k) investment activity trends reflect either inertia or participant learning or perhaps some of both. The August 2022 report of investment activity among 2+ million 401(k) participants with over $200 Billion in assets for the 2022 year-to-date activity (during the dramatic bear market decline) showed that less than 1% of participants changed their investment allocation!”
Why is this so? Towarnicky points to two prominent trends.
“First,” says Towarnicky, “median tenure has been less than five years for the past five decades, so over half of the active participants have less than five years of participation in their current 401(k); hence, the disproportionate impact of current year contributions. Since a prominent argument in favor of ESG investments is something called ‘long run interests,’ there is an obvious disconnect with most 401(k) plan investors. Second, the largest concentration among investments is now in target date funds. In their report on asset allocations in 401(k) plans for 2006, Employee Benefits Research Institute and the Investment Company Institute researchers never mentioned the words ‘target date.’ In the same report of activity in 2019, they noted ‘87 percent of 401(k) plans, covering 87 percent of 401(k) plan participants, included target date funds in their investment lineup … 31 percent of the assets … (among) 60 percent of 401(k) participants … held target date funds.’ Those percentages are likely greater in 2022!”
Towarnicky concludes, “participants voted with their investment ‘feet’ and decided against taking on investment duties.”
This is why you see 401(k) plan sponsors as the first line of defense when it comes to protecting investors. They don’t want to give employees enough rope to send their retirement to the “gallows,” as Towarnicky implies. On the other hand, they don’t want to absolutely prevent employees from making their own decisions.
“Long ago, in my role as an investment committee member for 401(k) savings and pension plans for my Fortune 100 employer, a wise actuarial friend surprised me by saying, ‘Over time, bulls and bears make money, chickens and pigs get slaughtered,’” says Towarnicky. “I learned that there is only one option that will succeed in ensuring participants avoid ‘follow the crowd’ and/or ‘aim for the fences’ behaviors in selecting ESG, crypto and other such investments: don’t offer those choices as core investments. Limit them to the directed brokerage account. However, any such ‘success’ may be short-lived if 401(k) assets end up in self-directed IRAs.”
You control your retirement investments. Be careful before allowing someone else to shame you into making a statement today, as you may unknowingly risk paying for it with your retirement tomorrow.
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