ESG and Fiduciary Responsibility: Part Three - In Search of ESG Impacts
In order to assess the validity of the decidedly negative perspective on the utilization of ESG factors in the investment of public pension portfolios that are presented by Ken Blackwell and the Institute for Pension Fund Integrity (IFPI) that we discussed in Part One and Part Two of this series, we decided to review some of the literature on this topic.
As we’ve said, the literature on ESG factor impacts is large and growing. One meta-study entitled “ESG and financial performance: aggregated evidence from more than 2000 empirical studies” published in the Journal of Sustainable Finance & Investment in 2015 evaluated evidence presented in 2200 studies performed between 1971 and 2014. While the findings of that study will be our topic in this post, we add that we reviewed more than two dozen research and other papers on the topic of the impact of ESG and SRI (Socially Responsible Investing) factors in both corporate financial performance and portfolio management. While our review was not exhaustive, we were consciously selective in, first, identifying studies summarizing other’s research and, secondly, deliberately balancing positive and negative research findings to obtain a fair sampling for purposes of this series.
Defining “ESG” and “CFP”
Turning, then, to the meta-study mentioned above, which we’ll call “Friede” since that is the name of the lead author, we note that the paper starts by doing what we probably should have done in our first post: Defining the scope of ESG criteria they considered.
As summarized in Friede, the study relied on an “exemplary list of variables” established in the literature over a 20-year time period. They also utilized a range of criteria commonly associated with E, S, G factor such as “environment(al) (performance), social (performance), responsib(le/ility), sustainab(le/ility), human capital, (corporate) financial performance.” Corporate financial performance, or CFP, “measures were defined as accounting-based performance, market-based performance, operational performance, perceptual performance, growth metrics, risk measures, and the performance of ESG portfolios.” We emphasize the last item because one of the key insights of the study measures and, to a limited degree, accounts for real world impacts on ESG factoring in mutual fund portfolios. We conclude this post with a discussion of that information.
Finding #1: ESG impacts = positive for CFP
Friede’s primary finding is stated very succinctly in both the abstract at the beginning of the paper and in a table that comes about 1/3 of the way in. That is that the “business case for ESG investing is empirically very well founded. Roughly 90% of studies find a nonnegative ESG-CFP relation…the large majority…report positive findings [and] the positive impact on CFP remains stable over time.” 
Finding #2: Positive CFP ≠ (necessarily) positive portfolio impacts
Friede’s second main finding emerges when non-portfolio studies are distinguished from portfolio studies. The distinction between the two is important because “performance in virtual portfolios and financial products such as mutual funds or indices may deviate from primary firm data.” That is to say that the positive CFP impacts identified in Finding #1 may be offset by other, non-firm/company portfolio-specific impacts as evidenced by “[s]everal primary portfolio studies and corresponding reviews report an abnormally low level of positive findings [and] a high level of mixed findings, compared to non-portfolio studies.”
For example, positive and negative screening approaches may cancel each other out from a portfolio impact standpoint and/or because portfolio studies account for “management fees…performance fees and trading costs [at an average of] roughly 2.5% per annum” making “[i]nvestors…unlikely to harvest the existing ESG alpha after implementation costs.”
We have argued in earlier posts on this site, fees and costs of various sorts appear to be a major, consistent determinant of under-/outperformance through and across markets, time periods and market environments. It seems that effect reappears in the ESG factoring area as well and ought to be borne in mind by any fiduciary, or person for that matter, considering whether to apply what seem to be corporate financial performance screens that correlate very highly with positive CFP outcomes (and should, under standard portfolio theory, translate to superior investment performance all other things being equal).
That said, Friede doesn’t really offer a strong case in support of Blackwell’s and IPFI’s derogation of ESG factoring in portfolio construction and implementation. In fact, Friede makes clear that the portfolio impacts noted are not, in themselves, sufficient reason to exclude or discount or ignore ESG factors because “investors in ESG mutual funds can expect to lose nothing compared to conventional fund investments.” That is to say, Friede’s data, as well as that of another study we will discuss in our next post-but-one, actually indicate that even after accounting for the cost impacts as a drag on realization of positive ESG impacts on corporate financial performance ESG funds perform, on average, in line with their non-ESG peers!
Friede’s findings may help us resolve the conflict we have identified between two of IPFI’s “Principles” presented and discussed in our two previous posts. However, before getting into that topic, we want to bring in a somewhat parallel critique from, in our view, a more credible source than either Blackwell or IPFI, the Center for Retirement Research at Boston College.
More to come next week!
Friede, p. 212, emphasis added.
Friede, p. 210 & 217.
Friede, p. 220, emphasis added.
“Does the Arithmetic of Active Management Add Up?”, Fiduciary Plan Governance.
Friede, p. 226.
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.