The Markets May 25, 2018

Industry Left Confused by DOL’s ESG ‘Clarification’

A review of industry commentary dissecting the DOL’s recently published Field Assistance Bulletin on the topic of ESG investments suggests the “sub-regulatory guidance” has left a lot of stakeholders with key questions.

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On April 23rd, the U.S. Department of Labor published a Field Assistance Bulletin providing guidance to fiduciaries of private-sector employee benefit plans as they consider implementing environmental, social and governance (ESG) investing programs for assets covered by the Employee Retirement Income Security Act (ERISA).

According to the DOL, the “sub-regulatory action” was not meant to substantially change the status quo with respect to ESG investing under ERISA, but instead merely to clarify how the new administration views existing regulations in this area. In particular, the Field Assistance Bulletin addresses Obama-era DOL 2015 guidance on economically targeted investments and related DOL 2016 guidance on shareholder engagement.

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According to an analysis of the new DOL bulletin shared by Northern Trust Asset Management, the DOL has confirmed once again that pension managers can and should feel comfortable using ESG factors as an input in evaluating potential risk and financial return. Still, given some of the strong language used to warn retirement plan fiduciaries against placing other interests ahead of the financial benefit of their participants, the bulletin has created some confusion.

“A common misperception about sustainable investing strategies (those that use ESG data) is that investors are giving up performance,” the Northern Trust experts write. “In fact, strong risk-adjusted performance relative to non-ESG investments is attainable. Proper due diligence is critical to confirm the objectives of sustainable investing strategies fit to the objectives of retirement plans. The most comprehensive study we have seen analyzed the findings of more than 2,000 previous studies and found that 90% of them confirmed that ESG factors had a neutral or positive relationship to financial performance.”

According to Northern Trust, the most recent DOL bulletin is “meant to clarify and reinforce the prudent fiduciary investment process that must always take place,” rather than to say that ESG investing rules are reverting to the stricter standards that existed prior to the 2015 reforms. As the firm points out, one line in particular from the DOL bulletin has garnered a lot of attention: “Fiduciaries must not too readily treat ESG issues as being economically relevant to any particular investment choice.”

“To some, this may appear that the Department of Labor is walking back from previous statements by saying that ESG is not material to risk and return analysis. However, we believe that these statements are building on, not replacing, statements (interpretive bulletins) from 2015 and 2016 recognizing ESG as a component of a prudent fiduciary investment process,” Northern Trust argues. “This is a modern view of ESG integration within a portfolio and is consistent with our sustainable investing philosophy.”

Overall, Northern Trust experts conclude the latest bulletin is “good news for plan participants as it underscores the importance of putting their needs first, while also allowing plan sponsors to respond to the growing demand and interest that participants demonstrate for access to sustainable investing strategies.”

“ESG analytics have become increasingly sophisticated over time and we believe the track records of investment strategies that use these analytics support decisions by retirement plans to add sustainable investing strategies to their menus,” the firm concludes. “This new guidance reinforces the principles and framework governing plan participation in ESG investments, but does offer clarification points for plans to consider. We continue to believe that ESG can play an important role in fulfilling retirement plans’ fiduciary responsibilities to their participants.”

Additional commentary

The U.S. Impact Investing Alliance, an advocacy organization working “to place measurable social and environmental impact alongside financial return and risk at the center of every investment decision,” shared similar commentary written by Fran Seegull, executive director.

“The guidance from the Department of Labor reaffirms the direct, material impacts that environmental, social and governance factors can have on financial performance, as demonstrated in the significant and growing body of financial and academic research,” she agrees. “It further confirms that pension plan fiduciaries may engage management—both directly and through proxies—In order to maximize the long-term economic value of their investments.”

Seegull further agrees that the DOL Bulletin “offers some notes of caution.”

“Still, we believe the economic case for evaluating the material impacts of ESG factors on both risk and financial return remains as clear as ever,” she says. “It is not without reason that a growing number of retirement plans, alongside leading banks, insurance companies, foundations and individuals, are recognizing that responsible long-term investment strategies demand a full and complete accounting of impact factors.”

According to the Alliance, with growing sophistication and reporting accuracy, investors are able to recognize, demonstrate and account for the materiality of ESG considerations on underlying financial performances.

“Though the Department of Labor has never mandated consideration of these factors, the Field Assistance Bulletin recognizes and reasserts that plan participants are increasingly demanding their plan sponsors consider ESG factors and make ESG-themed investment options available,” Seegull notes. “Managers are also increasingly aware of the fact that it may be imprudent to ignore these material risks and opportunities. Flows into U.S. funds that incorporate ESG factors were at an all-time high for the second year running in 2017.”

Seegull highlights a section of the most recent guidance, warning against incurring outsized costs in pursuing this type of ESG engagement.

“The guidance will spur efforts already underway to quantify the economic benefits of active ownership,” she speculates.

Perhaps most important for the retirement plan audience, the DOL bulletin offers new language around qualified default investment alternatives (QDIAs). As the Alliance reads it, the guidance “suggests that including an ESG fund as the default investment alternative would require a rigorous demonstration of its superior return expectations relative to other options.”

“However, including an ESG fund as one of many options for a participant to select from, particularly where participants are expressing a desire to invest in accordance with their personal values, remains appropriate,” the Alliance says. “Clear and consistent regulation benefits the industry. Although the bulletin language could chill the nascent growth of ESG target-date funds, financial services providers have always focused on the economic case for these exciting new products. The bulletin will help sharpen that focus and turn attention to the increasingly robust evidence base of ESG performance. The DOL should continue to work with the industry to ensure that retirement plan managers and participants have access to best-in-class financial instruments.”

ERISA attorney analysis

A detailed analysis shared by the Wagner Law Group makes some key distinctions about the various ESG regulations and pieces of supplemental guidance that must be considered.

As the Wagner attorneys point out, the DOL published its new bulletin to assist the Employee Benefits Security Administration’s national and regional offices as they respond to inquiries about the prior Interpretive Bulletin (IB) 2016-01, relating to shareholder rights and written investment policy statements, and IB 2015-01, relating to economically targeted investments.

“Perhaps not surprisingly, their current view on these issues is considerably narrower than those expressed by the prior administration,” the attorneys warn. “Although IB 2015-01 had apparently allowed the collateral benefits of ESG considerations to be taken into account in certain circumstances, such as a tie-breaker when the economic benefits of an investment were equivalent, in FAB 2018-01 there were circumstances when otherwise collateral ESG issues present material business issues that qualified business professionals would treat as economic considerations. In the DOL’s view, in these circumstances, the otherwise collateral ESG benefits would be more than tie-breakers. Only to the extent that these ESG considerations could properly be treated as economic considerations, could they be taken into account.”

The DOL follows this language with the warning to plan fiduciaries, in determining the prudence of a particular plan investment, that they should not too readily treat ESG factors as economically relevant to that particular investment decision. Rather, “ERISA fiduciaries must always put first the economic interests of the plan in providing retirement benefits,” and the “evaluation of the economics of an investment should be focused on financial factors that have a material effect on the return and risk of an investment based on appropriate investment horizons.”

Zooming in on the QDIA issue, the Wagner attorneys generally agree the new Field Assistance Bulletin may scare some plan fiduciaries away from using ESG considerations.

“While the DOL viewed it as acceptable to add a prudently selected, well-managed, and properly diversified ESG-themed alternative to a 401(k) platform, because that action would not require the removal or the foregoing of adding another non-ESG-themed fund, that analysis would be inapplicable to the selection of a QDIA,” they suggest. “From the DOL’s perspective, the QDIA regulations do not permit a fiduciary to choose a QDIA based upon collateral, public policy goals and present two different concerns. To the extent the fiduciary’s decision reflected its own policy preferences without regard to a possible different view held by plan participants, there would be a possible breach of the duty of loyalty.”

On the other hand, even if the interests of the plan fiduciary and the particular plan population were aligned, the decision might be imprudent if the fund selected would produce a lower rate of return than a non-ESG alternative fund with a commensurate degree of risk, or if the fund would be riskier than the non-ESG themed alternative with a commensurate rate of return.

In conclusion, the Wagner attorneys suggest FAB 2018-01 “would have been shorter and had fewer questionable interpretations of what was intended by prior DOL guidance had it indicated that it had changed its position on these issues.”

“It obviously makes it difficult for the applicable plan fiduciaries to operate in a frequently changing legal environment with respect to such an important fiduciary rule,” they warn. “Perhaps at some point the DOL will propose regulations for public comment, instead of providing sub-regulatory guidance through the issuance of Field Assistance Bulletins. Until such time, however, plan fiduciaries will need to act in accordance with FAB 2018-01.”

The Markets May 24, 2018

Researchers Explain Benefits of Global Bond Markets Allocation

Researchers from Vanguard say an investment that includes the bonds of all markets and issuers would theoretically benefit from the greater number of issues, securities, and markets, and their imperfect correlations through time, but they stress the importance of hedging against currency risk.

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An allocation to global bond markets gives investors exposure to a greater number of securities, markets, and economic and inflation environments than they would have with a portfolio composed purely of local market fixed income, according to a research paper from Vanguard.

“In theory, this diversification can help reduce a portfolio’s volatility without necessarily decreasing its total return,” say Todd Schlanger, David J. Walker and Daren R. Roberts, authors of “Going global with bonds: The benefits of a more global fixed income allocation.”

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The authors note that this wider exposure might, at first glance, seem to add risk, but they say an investment that includes the bonds of all markets and issuers would theoretically benefit from the greater number of issues, securities, and markets, and their imperfect correlations through time.

In many cases, the differences between markets can be substantial, representing local-market-specific risk factors that can affect a bond portfolio’s performance over time. “For example, a decision to overweight the U.S. bond market is, in effect, a choice to invest less in government bonds and more in corporate and securitized debt. By a similar token, the Canadian bond market is underweight central government bonds and significantly overweight government-related “provincial” bonds. Other overweights and underweights can be found for each local market by corporate sector, maturity, and credit quality,” the paper says.

The authors say, “The important point is that investors should be aware of and consider the impact of these risk factor differences in the context of their portfolio. An investment that, considered in isolation, appears to add risk can actually provide diversification through its interactions with other investments.”

The research found that various local market risk factors (such as interest rates, inflation, and yield curves) have resulted in relatively low correlations of government bond yields across markets over the past 50 years, suggesting a diversification benefit to increasing the number of global markets in a fixed income allocation. “For example, interest rates may be rising in one market and stable or falling in another, the net effect of which can be a dilution of or canceling out of interest rate movements, leading to a more stable return profile. For this reason, a global bond portfolio is typically less sensitive to changes in local interest rates than the weighted average durations of its individual bonds, which come from a wide range of different fixed income markets, would indicate,” the paper says.

The authors stress the importance of hedging global bonds’ currency risk. They explain that investing in global bonds results in exposure to two return streams, one from the underlying bonds and one from the accompanying currency translated back into the investor’s currency. “For example, if a U.K. investor were to purchase a U.S. Treasury bond denominated in U.S. dollars, both the interest payments and the principal repayment would need to be converted from U.S. dollars to British pounds, resulting in an additional return,” they say. “Hedging the currency of global bonds back into the investor’s own currency results in a return stream that is more typical of a high-quality investment-grade bond portfolio.”

The authors explain that the process of hedging currency involves using forward contracts that effectively lock in a set exchange rate based largely on differences in the prevailing interest rates that bring about a forward premium (or discount) to the spot exchange rate. “For example, consider a euro area investor who wants to purchase an Australian bond and hedge this exposure back to the euro. The investor would convert her euros to Australian dollars at the spot rate and purchase the bond. To hedge her Australian dollar exposure, the investor would enter into a forward contract to lock in a forward exchange rate. Often, the forward contract will not be equal to the spot rate, resulting in a forward premium or discount that represents an additional currency return that, combined with the return from the underlying bonds, will make up the investor’s total return.”

According to the report, in practice, currency hedging is implemented over relatively short horizons of between one and three months, resulting in a total-return profile that is similar to what an investor would achieve in her local bond market. The report authors say that historically, these currency returns have been positive in all markets included in their analysis: the United States, Canada, the United Kingdom, France (used as a proxy for the euro area), and Australia.

The authors clarify that when it comes to currency returns from global bonds is that over the long term, the currency returns from hedged and unhedged bonds would likely be similar, due to uncovered interest rate parity. This parity condition holds that interest rate differentials between markets will determine changes in exchange rates, so that the realized rate of return on a risk-free government bond is the same.

The authors say the currency returns from hedged and unhedged global bonds will differ slightly in the long term based on unexpected developments in interest rates and associated currency movements; however, in the shorter term, big gaps between the theory and the reality of uncovered interest rate parity create significant volatility. The research found that regardless of equity/bond asset allocation mix, local market, or currency, hedged global bonds provided risk-reduction benefits relative to leaving the currency risk unhedged. Over the analysis period, the risk-adjusted returns of hedged global bonds were, on average, 3.1 times greater than those of unhedged global bonds.

The authors also discuss in their research report how much unexpected depreciation it would take to justify leaving the currency unhedged; the costs of hedging global currencies; and sizing a hedged global bond investment.

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