The Corner

Markets

Panic on ESG Street

A Wall Street sign outside the New York Stock Exchange in New York City. (Carlo Allegri/Reuters)

The sub-headline in a Financial Times story on the anguished reaction of some asset managers to the Trump administration’s belated (if modest) efforts to protect the threat to pensioners’ investment returns represented by “socially responsible” investing (SRI) shows where the paper’s sympathies lie (not that there was any doubt about that):

Funds say Department of Labor rule would hamper ability to incorporate ethical principles into pension portfolios.

“Ethical” sounds so much nicer than ideological.

The Financial Times

Late last month, the Department of Labor proposed a new rule that would require private pension administrators to prove that they are not sacrificing financial returns if they put money in ESG-oriented investments. [ESG-oriented funds, amongst other considerations, look at how a company measures up against somewhat variably defined environmental, social and governance standards]

“Private employer-sponsored retirement plans are not vehicles for furthering social goals or policy objectives that are not in the financial interest of the plan,” said Eugene Scalia, the labour secretary.

Quite.

The Financial Times:

Critics argue that, instead of protecting retirees from decisions that prioritise politics over returns, the rule may put them at greater risk by hindering their ability to fully analyse the companies in which they invest.

In fact, there’s nothing in the rule to stop asset management companies doing the “full” analysis they need (the only question is the use to which they put that analysis), but some cynics might say that the objection to a rule that places some limitation to the degree to which certain ERISA-eligible funds can be managed on SRI principles might owe just a little something to the fees that “full” analysis can bring.

The authors of the DOL’s commentary on the proposed rules note:

ESG funds often come with higher fees, because additional investigation and monitoring are necessary to assess an investment from an ESG perspective.

Convenient.

The Financial Times:

“The Department of Labor, under the current leadership, is sceptical of sustainable investing and that is bad for retirement investors,” said Aron Szapiro, head of policy research for Morningstar, the fund ratings firm.

I wonder.

The Financial Times:

The new rule does not prohibit sustainability analysis outright, but it restricts defined contribution pension plans from offering ESG funds  as default investments — which is where many users end up, having not made an active decision on selection. It also requires fiduciaries to provide evidence that ESG-oriented investments have been chosen solely on “objective risk-return criteria.”

Mr Szapiro said: “There is no need for regulations on avoiding investments that are chosen principally to create some alternative benefit; it’s very clear you can’t do that and everyone knows that.” The strict requirements are intended to dissuade investors from “sniffing around anything that looks like ESG,” he added.

I’d pay attention to that word “principally”, something of a red herring. Mr. Szapiro is quite right that “everyone knows” that an investment structured like that wouldn’t fly. The question, rather, revolves around investment strategies where the supposed ‘alternative benefits’ reduce financial return from what it might otherwise have been.

The Financial Times:

US regulators are operating on an outdated perception of ESG, “which assumes that investors must give up performance in order to invest responsibly,” said Brendan McCarthy, head of defined contribution investments at Nuveen, a Chicago-based asset manager.

Nuveen and Morningstar are drafting critical responses to the proposal. The UN Principles for Responsible Investing, which has signed up nearly 2,300 investment managers, has also come out against the rule.

Ah, the UN. Reassuring.

The Financial Times:

“A lot of what we do with policy and regulatory work is just to bring the facts. And in this case, we will be bringing a lot of facts,” said Amy O’Brien, Nuveen’s global head of responsible investing.

Fiduciaries looking to make the case that ESG analysis can lead to outperformance can cite a growing body of research.

Last year, Bank of America found that companies with high ESG scores generally saw lower future earnings volatility, particularly within the energy, materials, utilities and communications services sectors. The bank also found that 90 per cent of S&P 500 companies that went bankrupt between 2005 and 2015 were among the bottom cohort of ESG performers.

But the outperformance of companies with high ESG scores is a complicated question. Back in May, Bloomberg’s John Authers looked at this issue, and noted this (my emphasis added):

It is possible that ESG is undermining itself — or at least that the E and the S are in conflict with each other. Vincent Deluard, of INTL FCStone Inc., suggests that ESG funds are people-unfriendly. Tech and pharma companies tend to look good by ESG criteria, but they tend to be virtual as well as virtuous. These are the kind of companies that need relatively few workers and which churn out hefty profit margins. When Deluard looked at how the big ETFs’ portfolios varied from the Russell 3000, the results were spectacular. They are full of very profitable companies with very few employees… A further look at companies’ market cap per employee showed that investing in the current stock market darlings who are making their shareholders rich is a very inefficient way to invest in boosting employment. They include hot names like Netflix Inc., Nvidia Corp., MasterCard Inc. and Facebook Inc….

The problem, Deluard suggests, is that ESG investing, intentionally or otherwise, rewards exactly the corporate behavior that is creating alarm. Companies with few buildings, few formal employees and a light carbon footprint tend to show up well on ESG screens. But allocating capital to them leads to a deepening of inequality, and intensifying the problem of under-unemployment. On the face of it, they aren’t the companies that should be receiving capital if employment is to recover swiftly. If investors want to behave with the interests of “stakeholders” rather than “shareholders” in mind, and that is surely central to the ESG philosophy, then their current approach is directly counter-productive. No good turn goes unpunished.

Oh.

What’s more, there’s some evidence that E, S and the generally uncontroversial G (governance) may affect performance in different ways:

Writing recently for the IFC Review, Julian Morris:

A 2016 paper from group of researchers from the European Parliament and Bournemouth Business School sought to look more deeply at the relationship, using disaggregated data from Bloomberg’s ESG Disclosure form for the S&P 500 for the period 2007 to 2011. The researchers found that the relationship between ESG and financial performance in general was indeed U-shaped. However, they found that the environmental and social components were linearly negatively related to performance. It was only the governance component that drove the U-shape relationship. This governance-dominated U-shape relationship between ESG and financial performance has since been confirmed in other studies.

In other words, if it’s financial performance you are after, focus on the ‘G.’

And as I noted in the same post in which I quoted Mr. Morris, the Financial Times (to its credit) had picked up on some comments by the SEC about ESG:

Jay Clayton, chairman of the Securities and Exchange Commission, said any analysis that combined separate environmental, social and governance metrics into a single ESG rating would be “imprecise”.

“I have not seen circumstances where combining an analysis of E, S and G together, across a broad range of companies, for example with a ‘rating’ or ‘score’, particularly a single rating or score, would facilitate meaningful investment analysis that was not significantly over-inclusive and imprecise,” said Mr Clayton…

The concerns expressed by Mr Clayton over combining E, S and G scores have previously been described as “aggregate confusion” by academics. One example of this is the electric car maker Tesla. The business, which scores highly on environmental metrics, has often been criticised for its record on workers’ rights. As a result, different ratings providers give it wildly different scores.

“Full” analysis can be like that.

The Department of Labor should stick with its proposed new rule.

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