By Bill Davis
Let’s talk about ESG performance in Q1 2020, when the S&P 500 Total Return was down 19.6%. Despite the fact that there are no real rules surrounding what defines ESG, it’s pretty clear that the industry as a whole fared better than more traditional approaches to portfolio construction in terms of performance. In an April 3rd, 2020 piece by Morningstar entitled “Sustainable Funds Weather the First Quarter Better Than Conventional Funds”, the author, John Hale points out that “7 out of 10 sustainable equity funds finished in the top halves of their Morningstar Categories, and 24 of 26 environmental, social, and governance-tilted index funds outperformed their closest conventional counterparts.”[1]
To be sure, ESG detractors make the selection effect argument that ESG portfolios disfavor fossil fuels and lean into sectors of the economy such as technology and health care, which have proven to be more resilient during COVID around issues such as working remotely, paying living wages, and providing paid sick leave. So of course, they did better during this one market cycle, but that doesn’t mean they’ll do better in the long run.
But isn’t the point of ESG investing to identify sectors of the economy with less material risk? I’m not suggesting that ESG managers predicted the Q1 collision of a Russia/Saudi oil price war and a global healthcare pandemic. Consider instead that ESG investors have been mindful of a larger, seemingly slower moving pandemic called climate risk, and that as the world transitions to lower carbon economies, the potential for stranded (fossil-based) assets represents a material risk factor to performance. While very few of us that build ESG portfolios saw this playing out the way it has, most of us have been preparing for climate-related disruptions for some time.
So why to this day are there still refrains of “the jury is still out on ESG”? I’m not referring to isolated observations, but rather large swaths of consultants, institutional investors, OCIOs, family offices, and especially retail advisors. Far too many financial professionals are missing the point that ESG isn’t about blue state politics but rather risk management. Climate risk is systemic risk and will therefore implicate every company in every industry in every geography. Thus, climate risk is also portfolio risk, and brings to light issues that all investors, especially ESG skeptics, need to consider or face the wrath of the markets.
I believe the ESG industry has been too complacent with its detractors, too willing to be guilty by association with pre-ESG approaches to ethical investing based entirely on negative screening, and too intimidated by investment committees that drone on about fiduciary duty. Put another way, we have a confidence problem. And in order for assets to flow more freely into ESG investing, we need to do a better job of highlighting why ESG investing protects downside risk. We also need to fight for assets by taking this message to the end clients, be they institutional or retail, because the gatekeepers in the middle are confusing the past with the present, and in general, clogging the arteries of progress toward resilience.
Speaking of fiduciary duty, the U.S. Department of Labor very recently issued a proposed rule that would confirm “ERISA requires plan fiduciaries to select investments based solely on financial considerations relevant to the risk-adjusted economic value of a particular investment or investment course of action”.[2] Put differently, plan fiduciaries must not sacrifice performance or expose the plan participants and beneficiaries to additional risk by including investment options that primarily serve social or ESG interests of the plan fiduciaries. This will be interpreted by many fiduciaries as a reason to avoid ESG considerations.
The irony of course is that by allowing themselves to be whipsawed by political ping pong on the question of ESG and fiduciary duty, they are in effect putting participant assets at greater risk of underperformance. Certainly, fiduciaries should have a very high standard around performance. And if ESG strategies are generating strong performance, then the ESG attributes are essentially free, and shouldn’t be discounted because of an ESG label.
More importantly, the idea that social benefits shouldn’t be factored into investment analysis misses the point that some of these social benefits, such as providing paid sick leave, actually contribute to financial performance. If a company is a laggard in these areas during COVID, workers are more likely to continue working, thus endangering other workers. When this results in a facility shutdown, financial performance is threatened.
So, is this a social issue or a material risk to performance?
The DOL might be advised to check with their own Bureau of Labor Statistics which as of this past March reported that 24% of U.S. civilian workers, or roughly 33.6 million people, do not have paid sick leave, and are thus more likely to continue working during a healthcare pandemic.[3] Informed by watchdog organizations such as The Shift Project, ESG fund managers have the opportunity to avail themselves new data sources with which to access material performance risks in areas such as paid sick leave, living wages, etc..[4]
In the past, we’ve allowed social components of portfolio construction to be framed as soft preferences, but we can no longer afford to be defined by outdated and compartmentalized approaches to risk management. The overarching pandemic of climate risk is just beginning to manifest itself through the financial markets, and ESG managers have a unique set of tools with which to dynamically assess off-balance sheet risks.
It’s been a long time coming, but it certainly feels as though ESG is starting to be recognized for what it is: an essential tool in managing risk.
[1] “Sustainable Funds Weather the First Quarter Better Than Conventional Funds” www.morningstar.com, 3 April 2020, https://www.morningstar.com/articles/976361/sustainable-funds-weather-the-first-quarter-better-than-conventional-funds.
[2] “Financial Factors in Selecting Plan Investments” Employee Benefits Security Administration, Department of Labor, 30 July 2020, https://www.federalregister.gov/documents/2020/06/30/2020-13705/financial-factors-in-selecting-plan-investments.
[3] “Employee Benefits Survey” U.S. Bureau of Labor Statistics, 17 March 2020, https://www.bls.gov/ncs/ebs/factsheet/paid-sick-leave.htm
[4] https://shift.hks.harvard.edu/