The investment committee chair from one of your plans sent you an email asking for your input on adding an ESG (environmental, social and governance) fund to the 401(k) plan’s lineup. Employees have been contacting the HR department to express interest in having a responsible investing option, which the plan currently lacks. Could you put together a presentation for the next investment committee meeting with your thoughts on possible fund additions?
Whether it’s called ESG, responsible investing or sustainable investing, interest continues to grow rapidly in these approaches. If your sponsors and participants aren’t asking about ESG already, you can expect inquiries soon. According to US SIF: The Forum for Sustainable and Responsible Investment: “Assets under professional management that take ESG factors into account in the United States increased by 42 percent between 2018 and 2020 from $12.0 trillion to $17.1 trillion, representing one out of every three dollars under professional management. While most of this activity has been from institutional asset owners, studies from the Morgan Stanley Institute for Sustainable Investing and Natixis Global Asset Management show that demand from individual investors is on the rise.”
Even when a plan expresses interest, though, it’s likely to be cautious. The regulations when considering equity and fixed income funds for a plan lineup are clear-cut. But while the Biden administration is seen as favoring ESG-focused investments, regulators’ attitudes have varied over the years. Consequently, some plan sponsors are hesitant to add ESG options within target date funds before the Department of Labor’s position is fully clarified, says Tim Kohn, head of retirement with Dimensional Fund Advisors (DFA), adding that he expects clarification will arrive very soon.
Evaluating ESG-Focused Investments
Most plan consultants will have a well-documented process for reviewing funds under consideration for or already in a plan’s lineup. That process will include data from multiple sources and it’s likely a third-party analytic service’s fund rating will be a factor.
But evaluating ESG performance can require different data and different metrics and the resulting ESG ratings are a source of some dispute. A May 2021 DFA whitepaper, “ESG Data, Ratings and Investor Objectives,” reports that ESG ratings providers “frequently disagree on company ratings.” For example, a “company may be identified as best-in-class by one provider and as average by another provider.”
The paper suggests caution when using ESG ratings: “Given the subjectivity inherent in ESG ratings, we believe they should be viewed not as objective ratings, but as opinions—not unlike the buy/hold/sell opinions that have been issued by sell-side analysts for decades. When using ESG ratings from one provider to allocate assets, investors should be aware that other ratings providers may have dramatically different opinions and ratings.”
A second DFA whitepaper, published in August 2021, “Beyond the Label, ESG Funds May Miss Their Mark” also urges caution when reviewing ESG funds. The paper’s key takeaways:
- “Components of ESG in an investment strategy, how they’re measured, and the method of incorporation can lead to a wide range of investment outcomes.
- ESG strategies exhibit a broad spectrum of characteristics, which may drive expected returns that differ from the market.
- Greenhouse gas emissions exposure has varied substantially across ESG strategies, highlighting the importance of looking beyond ESG labels to determine whether an ESG investment is consistent with one’s goals.”
Staying on Track
Will Collins Dean, senior portfolio manager with DFA, has several suggestions for consultants and sponsors who are starting to evaluate ESG opportunities. One option is to go with a clearly stated ESG goal instead of a “kitchen sink” approach. For instance, focusing exclusively on greenhouse emissions or corporate governance versus a broad approach can improve research efficiency and the resulting analysis. “We oftentimes see a lot of offerings that are trying to tick the box on a large number of ESG variables and in doing so you can end up in two states,” Collins Dean explains. “You could end up with a very concentrated offering or you could end up with an offering that's diversified, but it's not moving the needle significantly in any one particular direction because you have these offsetting effects with the large number of variables.”
It’s also essential to maintain perspective on ESG-investments’ role as a portfolio component, says Collins Dean. “Just because you're evaluating an ESG option, you shouldn't sacrifice those core tenants that we think are really important when it comes to a reliable investment approach: diversification, cost, effective implementation, (and a) systematic approach to pursuing securities with higher expected returns,” he says. “Those are just as important in the ESG space as they are outside of the ESG space.”