ESG and Fiduciary Responsibility: Part Four

In November 2016 the Center for Retirement Research at Boston College issued a “brief” entitled “New Developments in Social Investing by Public Pensions.” Co-authored by Alicia Munnell, the director of the Center as well as a named-chair professor at BC’s business school, the paper provides a high-level, overall survey of the then-current state of ESG factor investing. The substance delves into divestment efforts, the economics of social investing as well as associated “economic, political, and legal complications” of the practice. It concludes, as stated in the introductory section, that “although social investing may be worthwhile for private investors, lower returns and fiduciary concerns make public pension funds unsuited for advancing ESG goals.”

Before discussing our reaction to the piece, I want to note that we approached it with interest and high expectations as we have followed and respected the Center’s work for years. By the time we took it up we had read some dozen or so research reports, white papers and other ESG-related publications and appreciated the Center’s focus on two particular questions:

1) Can ESG-screened portfolios meet the same return/risk objectives as non-screened portfolios; and

2) Are public plans the right vehicle for advancing ESG goals? [1]

In short, the Center’s answer to those questions is “No!” Here, in summary, are their reasons:

· ESG screening actually “is likely to have very little impact on the target company” because investors not constrained by ESG criteria will step in to take advantage of any negative price activity in a company’s stock thereby returning the shares to their correct value;

· Since diversification “needs only 20-30 stocks for a portfolio that reflects the whole market” there is an increased risk of failing to “duplicate the market” and, thereby, imprudently constraining investment performance;

· This risk seems to be confirmed in that actual relative performance from 2001-2015 of “plans in states with divestment requirements are estimated to be 40 basis points lower” than in those without such requirements;

· Further confirmation of apparent underperformance is also found in comparing the performance of ESG-screened mutual funds “with comparable Vanguard mutual funds for five asset classes. Those are: Large and mid-cap domestic equity, international equity, short and long-term domestic bonds.

Concerning the last bullet point, the Center presents blended average return data for (we have to assume) all ESG funds in each asset class that had, through August 2016, a history of returns at least 10 years in duration. On a simple raw count of 1-, 5- and 10-year periods:

· Large cap domestic equity: The ESG blended average outperformed in no periods with the gap being 4.1% for 1 year, 2.6% for 5 years and 0.06% for 10 years

· Mid-cap domestic equity: The ESG blended average outperformed in two periods, albeit by miniscule amounts of 0.01% and 0.04% in the 1- and 5-year periods

· International equity: ESG outperformed in the 10 year period, 4.9% vs. 4.4% while underperforming by 2.01% for 1 year and 2.00% for 5 years

· Long-term domestic bonds: Once again, ESG outperformed in the 10 year period by 0.01%. For 1 year, underperformance was 4.1% and 2.00% for 5 years

· Short-term domestic bonds: ESG failed to outperform in any of the periods, falling short by 0.04% for 1 year, 0.03% for 5 years and 0.02% for 10 years.

Now that is interesting information. It definitely gave us pause…until we reflected a bit and realized that, as anyone who follows the markets at all certainly knows, the decade up to and through 2016 was extremely difficult for all investment managers, whether they applied ESG screens of not, who were not index funds! So, we decided to take a look to see how the various peer groups performed relative to their benchmarks through the end of 2016. [2]

· For large cap domestic equity, the peer group Morningstar Large Blend category underperformed in all four [3] periods

· In the mid cap domestic equity category, we noted that the Center used the Russell Mid Cap Value benchmark, the peer group underperformed in 3 of 4 periods

· Likewise in the international equity category, the peer group underperformed in 3 of 4 periods

Looking more broadly to include the range of large, mid, small domestic equity categories (blend, growth and value) we discovered that of the 36 periods the peer groups underperformed their benchmarks in 94.4% (34 of 36). Perhaps the problem lay not in ESG screening but was a broad-based phenomenon afflicting all categories of domestic asset managers? Hardly a framework that supports the Center’s conclusion, we think.

Next time, we turn to the Morningstar study that Ken Blackwell, whose column got us looking more closely into all this, claimed (incorrectly) supported his thesis that ESG and fiduciary duty don’t fit together well or at all.

[1] Munnell, Alicia H. and Anqi Chen. “New Developments in Social Investing by Public Pensions.” Center for Retirement Research at Boston College. Number 53, November 2016. p. 1.

[2] Our resources being less extensive than the Center’s, we were not readily able to match the exact periods. However, the final six or seven weeks of 2016 were extremely positive for domestic equity investors. By extending our evaluation period through the end of the year, we feel we are giving investment managers’ performance an additional boost by which they can be compared.

[3] We also looked at the 3 year period ending 12/31/2016.

Ed Lynch is founder and CEO of FPG. He has worked with ERISA-qualified plan sponsors and designated fiduciaries in most aspects of plan development and maintenance since the early 1980s. Ed founded FPG with the mission to be a leader in the field of employee benefits and the most trusted source of information and evaluation in the retirement plan industry.