John Dealbreuin
Wealth of Geeks
On March 20, 2003, President Biden issued his first veto, rejecting bipartisan legislation that would have overturned the Labor Department’s ruling to allow retirement plans to incorporate “environmental, social and corporate governance (ESG) principles” into their investments.
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Background on the current Department of Labor rule
In 1974, the Employment Retirement Income Security Act (ERISA) was passed by Congress to protect private retirement and healthcare investment accounts from unscrupulous managers who may attempt to defraud unwitting investors. ERISA set essential standards for account management that would guarantee maximum profits while curtailing fraud.
In Nov 2022, the Biden administration issued a rule stating that investment advisors can consider climate change and other ESG factors when selecting retirement investments for their clients.
Before this, the ERISA regulations stipulated that account managers make decisions to invest based solely on what would generate maximum profits for their clients and prepare them to enjoy a steady retirement lifestyle.
It is imperative to note how much of an alarming difference this shift in precedent makes. For the first time, retirement account managers could potentially decrease returns on retirees’ investments without authorization to accomplish environmental, social, and governance objectives.
U.S. Senator Joe Manchin (D-WV) said, “This ESG rule will weaken our energy, national and economic security while jeopardizing the hard-earned retirement savings of 150 million West Virginians and Americans. Despite a clear and bipartisan rejection of the rule from Congress, President Biden is choosing to put his Administration’s progressive agenda above the well-being of the American people.”
Backers of ESG investments champion that adhering to these rules can bring people financial gain, contribute positively to the environment, and reduce potential fiscal risks due to climate change.
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ESG investing trends
In 1970, Milton Friedman penned an essay for The New York Times titled “A Friedman Doctrine: The Social Responsibility of Business is to Increase Its Profits.” He argued that a company has no social responsibility to the public or society; its only commitment is to its shareholders.
Times have changed.
Many clients are concerned with environmental and social impacts. So naturally, they want to also invest in line with their principles. As a result, ESG investing has exploded.
Companies realizing that a high ESG score favorably impacts consumer behavior have started including more information about their ESG programs.
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What are the benefits of ESG investing?
Some of the most commonly mentioned benefits of ESG investing are:
• Helping environmental and ecological causes.
• Holding companies accountable for their actions
• Rewarding ethical companies based on their principles.
• Ensuring a positive impact on the local communities.
• Obtaining decent returns while making a difference.
However, matching the actual impact of ESG investing to the touted benefits is challenging.
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Reasons why ESG investment funds are not effective
• ESG principles are not cheap
Over the long run, stock prices reflect a company’s profit. As a result, one cannot adhere to the ESG principles and outperform peers in the same sector. A Journal of Financial Economics research paper indicates that investing in sin stocks is more profitable.
• ESG funds are actively managed
Although ESG funds track their respective indexes, the index is actively managed.
Based on the ESG scores, a fund manager actively makes buying and selling decisions. Besides the tax implications, you also have higher fees for active management efforts. Academic research has shown that actively managed funds underperform passive index funds after expenses.
• Reduced diversification
The criteria of ESG scores exclude entire sectors such as energy. Similarly, the Socially Responsible Investing (SRI) criteria exclude tobacco, alcohol, and casino stocks. Thus, you would reduce exposure to several industries following ESG or SRI scores.
• Secondary market price impacts behavior to a minimal extent
A fundamental concept ESG advocates need to realize is that a lack of appetite for stocks on the secondary market has no significant impact on a company’s operations.
Shares currently trading on the secondary market may fall in price if no one buys them, but that exchange is between existing holders of the stocks and future sellers. The company is not involved in this transaction in any manner.
• The definition of ESG is subjective
Although ESG scores are available, fund managers have tremendous latitude in interpreting ESG factors and constructing ESG funds.
Wall Street has created several ESG funds to exploit the investor interest in ESG. However, the criteria for inclusion and exclusion in ESG ETFs still need to be clarified.
The U.S. Securities and Exchange Commission (SEC) has taken notice and announced it was creating a Climate and ESG Task Force to “proactively identify ESG-related misconduct,” such as inaccurate or incomplete disclosures by funds and companies.
ESG is an excellent concept to invest in as per your belief system. After all, we should vote with our money. However, be skeptical of the promised benefits of ESG investments.
With Congress needing a two-thirds majority to overturn the veto, the veto will likely remain intact. This means ESG criteria will now be among retirement plan fund options.
