Warming to ESG

For the last 60 years, modern portfolio theory has held that investors should apply rigorous quantitative methods to seek out those investments with the highest expected return available—without regard to the nature of the business that is producing it. Going back even further, though, a century or more, a subset of concerned investors began focusing, instead, on the heart and soul of potential investments, insisting a company have strong ethics and values. This philosophy was formalized in the 1970s into socially responsible investing (SRI), which shuns firms in industries deemed detrimental such as tobacco, alcoholic beverages, gambling or armaments.

A more recent offshoot of SRI, “ESG” investing, takes an alternative, affirmative approach, by embracing companies that contribute to the general well-being. ESG methods select companies based on: how they handle natural resources, including the air and water—Environmental; how they act on equality of pay and opportunity, management of supply chains, data security and interactions with customers—Social; and whether they field diverse and progressive management teams and directors—Governance. ESG has become well-established among global institutional investors and is beginning to take hold in some corners of the defined contribution (DC) world with forward-thinking DC sponsors, participants and investment providers, who are trying to make it mainstream.

At the start of 2016, 26% of professionally managed assets in Asia, Australia and New Zealand, Canada and the U.S., equal to $23 trillion, was managed under some type of social criteria, according to the Global Sustainable Investment Alliance. Long-time advocates include institutions with charitable inclinations such as endowments and foundations, but a 2017 survey by consulting firm Callan Associates found that, after a recent surge, 25% of U.S. corporate defined benefit (DB) pension plans had adopted ESG investing, as had 35% of public funds. Moreover, ESG is popular with individual investors, whose assets made up one-third of the $8.7 trillion invested sustainably in the U.S., Callan reported.

However, while there is plenty of effort devoted to ESG among institutional investors, the uptake by 401(k) plans is still small. The 2018 PLANSPONSOR Defined Contribution Plan Benchmarking Report states that about 12% of plans make socially responsible options available, and Vanguard’s “How America Saves 2017” notes that just 3% of participants who are offered socially responsible funds use them.

If interest in ESG is concentrated among younger investors, that suggests potential for growth as their savings build. In its 2016 survey of DC plan participants, Natixis Global Asset Management, which launched the first ESG target-date fund (TDF) series last spring, found a strong interest in having a personal connection with investments. About 80% of participants surveyed wanted their investments to reflect their personal values, and 62% said they would increase their contributions toward socially positive investments—72% among the Millennial cohort. Three-quarters of all respondents expressed a desire for more options in social investing.

“We now discuss ESG in every meeting we have,” says Sabrina Bailey, global head of retirement solutions at Northern Trust Asset Management, in Chicago. “Smaller to midsize plans have been reaching out to us, and we’ve seen a greater increase in demand than ever, so we’ve become proactive with sponsors. Poor environmental, social and governance conduct by companies hurts their stock prices, so why wouldn’t you want to help your participants avoid those risks?”

Benchmarking Performance

In terms of investment track records, management with the benefit of an ESG lens is fairly new, making its effectiveness hard to evaluate. In addition, ESG takes many approaches. “ESG strategies are created in every conceivable way, and some are more ‘sincere’ than others,” observes Andy Iseri, senior vice president at Callan, in San Francisco.

“Some managers build their ESG portfolios from the ground up,” Iseri explains, “but more common are traditional strategies that have ESG components in the existing investment process or are evolving to include ESG considerations for the first time.” Managers can make their own in-house judgments on which companies clear the ESG bar, or rely on the expertise of third-party specialists such as index provider MSCI and long-time ESG researcher Sustainalytics.

Data providers are developing performance attribution measures to better isolate the impact of ESG, although it may be some time before those measurements yield meaningful information, Iseri adds.

“That said, ESG indices have generally outperformed standard indices marginally since the global financial crisis,” Iseri points out. “[But] from anecdotal evidence of managers that offer ESG and non-ESG versions of the same active strategy, there’s been general underperformance of the ESG versions. In each case, however, the performance differences are very small.” Indeed, for the five years ended this past December 31,  the paths traced by MSCI’s World and counterpart World ESG Leaders indices have followed each other quite closely.

Performance is just one consideration, however, and the requirements of the DC world make the decision to offer an ESG fund a bit more complicated. “ESG can make its way into DC plans—or may have already done so—in three ways,” Bailey says. “The first is historically, in plans run by socially conscious organizations such as churches, hospitals and schools. They’ve had SRI or ESG options for years.”

The last five years have seen greater interest from the corporate world, she adds, from two additional directions. “The first is senior management, where companies have stated a social responsibility initiative and want to make their DC plan investments part of that. The second is driven by the participants, in particular women and Millennials.”

But for sponsors, offering ESG means facing trade-offs. For one thing, a new option runs counter to a goal many sponsors have: to streamlining core menus. Then there is choosing the fund and whether to narrow the ESG focus to companies with the same objective such as reducing carbon emissions, and then choosing among index funds, or among strategies that are actively managed.

“With ESG, there is a balancing act between cost efficiency, simplicity and customization,” observes Brendan Curran, head of U.S. defined contribution investment strategy at State Street Global Advisors in Boston. “If a sponsor is adopting ESG to align with its corporate philosophy, it has to balance that against what investment options are available and not let the perfect get in the way of the good, especially at the small end of the market.”

Fund researcher Morningstar has developed an ESG ranking system that comprehensively analyzes funds that declare an ESG objective. Most ESG-specific funds invest in developed market equities, but options are also available in fixed income, emerging markets and specialty areas such as real estate. Morningstar counted about 200 open-end and exchange-traded fund (ETF) choices for ESG at the end of third quarter 2017 and cited the opening of about 40 new funds in the category for the full year.

The Morningstar system also ranks conventional funds for their ESG content—it might surprise some advisers to learn that many investments have this exposure. “A lot of funds are already highly rated without being actively managed for ESG factors,” says Jim Marshall, president of Spectrum Investment Advisors in Mequon, Wisconsin. “We analyzed 30 non-ESG funds we use, and a good half were rated above average in ESG by Morningstar. With this approach, you can achieve ESG goals from existing funds and get a diversified portfolio.”

Art by Graham Yarrington