The ABCs of Investing in ESG Funds in Retirement Plans

The Department of Labor (DOL) has proposed removing barriers put in place by the Trump administration that would have limited plan fiduciaries’ ability to offer environmental, social and governance (ESG) funds in retirement plans. The DOL had previously proposed restricting the use of these funds and imposing unnecessary burdens on plan sponsors. The previously proposed rule received a lot of industry backlash because of the built-in assumption that ESG funds would underperform the less constrained funds.

A separate Trump rule had proposed barring plan sponsors from voting proxies in favor of social or political positions that don’t advance the financial interests of retirement plan participants. This rule would also be overturned in the new proposed “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholders Rights” bill. The Biden administration has been outspoken in their support of the environment, and their belief that climate represents a significant risk to the economy.   

What’s the Appeal of ESG?

Over the last several years, we have seen broad adoption of sustainable funds, the broad universe that includes Socially Responsible Investing (SRI), ESG, and Impact investing. According to the US SIF biennial report, the total US assets under management for sustainable investing grew from $12 trillion in 2018 to $17.1 trillion in 2020, an increase of 42 percent. This represents nearly one-third of the US professional assets under management, an astounding 25-fold increase, or 14 percent annualized growth rate, since 1995. This includes large pension plans, endowment & foundations, family offices, and individual investors.

The primary appeal of ESG investing is doing good and doing well. In other words, ESG investing allows investors to align their views and values with their portfolios, by investing in companies with sound environmental practices, a diverse and engaged workforce, and strong checks and balances. Multiple studies have shown that ESG screening helps in identifying good companies, and avoiding bad ones, leading to outperformance over the long run.

When considering sustainable investing, advisors and investors often focus much of their attention on the environment and do not always consider the merits of the social and governance pillars of ESG. Individually, each helps in identifying good companies with sound policies and practices. Collectively, asset managers and index providers combine the E, S, and G in a portfolio. The weighting across pillars may depend on each industry or may be optimized to provide a particular outcome.

Environmental screening identifies companies focused on issues such as climate change, energy consumption, the use of natural resources, and reduction of their carbon footprints, among other issues. These companies typically have policies for dealing with the environment, consuming energy, and disposing of waste.

Social screening identifies companies with strong employee engagement, good human rights track records, broad employee diversity, and fair labor practices. These companies recognize the value of diversity and the need to embrace employee differences. They proactively promote minorities, often encourage mentoring, and engage their communities.

Governance screening identifies companies with independent and diverse boards, fair compensation practices, and strong checks and balances. They encourage independent points of view and strong boards of directors. Their disciplined risk management typically lets them avoid reputational risks.

These are independent pillars. A company may have a high E score and a low S score, or a high G score and a low E score. A firm might have a diverse board and strong social policies but produce fossil fuels; it could hire and promote minorities but lack diversity on its board. A company that scores well across the E, S, and G pillars likely exhibits strong social policies and procedures, a track record of caring for the environment, and good corporate governance.

It is also important to consider how these pillars are weighted and incorporated. Much like traditional indexing, there can be dramatic differences between equally weighting the pillars, market-cap weighting, or using some form of optimization. The combination of pillars produces a diversified portfolio of companies.

Investors may also be able to isolate the types of exposures they’re seeking by investing in such niche areas as climate change, alternative energy, and gender equality among others.

Beware of Greenwashing

With the incredible growth of sustainable investing funds, many asset managers have, or are evaluating launching new strategies and/or repositioning existing strategies. Greenwashing (also called “green sheen”), where companies are primarily interested in raising money rather than in having an environmental impact, is becoming more of a concern.

Greenwashing is the process of conveying a false impression or providing misleading information about how a company’s products are more environmentally sound. Greenwashing is considered an unsubstantiated claim to deceive consumers into believing that a company’s products are environmentally friendly.

For asset managers, greenwashing can involve claiming to incorporate sustainable screening but not following acceptable guidelines; or making misleading claims about the investment team’s tenure and experience. There are firms with well-established teams and disciplines dedicated to sustainable investing, and those that are greenwashing to gain market share. Advisors can help investors parse through the noise and focus on asset managers and funds that have a history of managing ESG assets. 

As with consumer products, sustainable investment products should be truthfully labeled. Firms should be transparent about how they evaluate sustainability and how they use sustainable investments to build portfolios. With an influx of new strategies coming to the marketplace, investors should question newer strategies to determine whether their process truly incorporates sustainability screening. Review the company culture and practices, the investment team’s tenure and track record, as well as the underlying portfolio holdings.

One easy step to see if an asset manager has ESG in their DNA, or if they are merely focused on growing their assets under management, is to evaluate the diversity of their leadership and investment teams. Do they truly believe in the value of diverse views and perspectives, or are they merely donning the ESG moniker to garner assets?

Next steps . . .

Not all ESG funds are created equally, and investors should take the time to carefully evaluate the options available to them. They may want to leverage the expertise of an experienced advisor, and incorporate a checklist:

• How do they screen and weight securities?
• What is the weighting across pillars (E, S, & G)?
• What has been the historical performance (return and risk)?
• What is the portfolio management team’s experience?
• Do they have experience in managing ESG portfolios?

ESG investing has become a mainstream option for allocating capital. Like all investing, investors should understand the fund’s investment approach, the historical returns and risks, and the team managing their retirement assets. Wealth advisors should take the lead in educating investors about the merits of ESG investing and help them make better informed decisions.