“ESG Investing” represents an approach targeting investments based on their scores in the areas of Environmental, Social, and Governance (“ESG”). In our last column, we addressed the danger to our banks and our financial system when government officials and bank management were more concerned about their ESG scores than their solvency. Now we identify the risks of ESG Investing to Main Street USA as shareholders and retirees, as well as the potential impact to all investors from the Biden Administration’s Department of Labor rules for fiduciaries.
It has become a mantra for social justice warriors to put “people before profit.” What does this mean? Are those investing in their own retirement not people? Yet retirement funds and other investing entities have allowed their political and social aspirations, expressed as “ESG,” to supercede their traditional fiduciary responsibility for prudent return on capital invested.
To protect these ESG causes from fiduciary duty, President Biden vetoed a bipartisan bill to nullify a November 22, 2022 administrative rule to fiduciaries to weigh climate change, social justice causes, and other ESG factors when considering retirement investments. Moreover, under the rule, fiduciaries are now protected from lawsuits should these choices result in lower returns or loss of capital. This was Biden's first veto and comes in the wake of the collapse of woke banks such as Silicon Valley Bank.
Wall Street investment firms have developed a cottage “ESG industry” acting as self-appointed sherpas to “guide” companies, investors, and investment managers through ESG investments. Sadly, these firms have co-opted “green environmental” benefits to serve their “green pocketbooks.”
Dive Into the ESG Investment Funds
“Following Your Money” jumped directly into the ESG-themed Exchange Traded Funds. We sorted for the 5 largest ETFs claiming an ESG investment approach. Then we gleaned those earning 4 or more stars from Morningstar, a most notable evaluator of funds and their management. This approach ensured we evaluated not only the most commercially successful ESG funds, but also the most highly regarded for investing acumen. We then compared these funds with large non-ESG funds that earned similar ratings. As shown in the chart below, ESG funds performed almost identically to non-ESG funds – but featured far higher expense fees.
Top 10 Investment Holdings, Portfolio Performance. Notice the first column in ESG funds v. the first column in non-ESG funds are almost identical, yet the expense fees are far higher for the ESG fund.
For ESG Investing to be a suitable approach to fund our retirements and enhancing our lifetime legacy, we examined three key issues:
• What are the financial results of ESG-driven investing versus traditional fiduciary-oriented investments?
• What are the standards for the scoring of ESG investing?
• Has ESG Investing been effective in improving outcomes in the areas of Environmental, Social, and Governance?.
What We Learned
• Not only can an investor select a non-ESG fund with similar investment performance to ESG funds, the non-ESG funds will have lower fees.
• You get very similar investment holdings regardless of ESG label. The Top Ten Holdings of the largest ESG funds had eight of same holdings in its non-ESG equivalent. In one case, the top eight mirrored exactly, and in exact order.
In other words, these fund managers have simply mirrored their top selling index funds, slapped "ESG" on the name, and charged more for what is essentially the same thing.
When did this go off the rails?
Investing in companies that provide products and services that appeal to niche investors, who wish to practice “social responsibility,” is not new. Forcing investors’ money into these investments is very new.
Religious groups such as Quakers and Methodists have long been noted for pooling their investments to avoid “sin stocks”. They believe certain companies' products and services adversely impact the health of their members. The transparency to those wishing to invest with their group is well-known and far from compulsory. There is no “scoring” to rank the level of “sin.” No company would be selected for investment simply because it was deemed less sinful than its competition. Bad was always “Bad” and didn’t need to be quantified.
This theme has mutated into the ESG paradigm where some employers’ pension and 401(k) retirement plans can provide only choices where ESG ratings reign supreme above financial returns.
There are no universal criteria for identifying what management practices or results are “ESG.” For instance, a company’s Financial Statements are audited by licensed CPA firms according to Generally Accepted Accounting Principles. Quality Audits are performed against a standard such as ISO-9000 by a certified Registrar. There is no on-site audit requirement for testing the accuracy of management’s ESG claims, or a certification process for analysts and statisticians compiling and computing their ESG scores.
ESG Scoring and Fund Management Became a Cottage Industry Unto Itself
Many organizations compile ESG scores utilizing statistics from public sources, but with no consistent methodology for tabulating results, weighting components, or statistical analysis of attributes.
The industry is comprised of various financial data gatherers such as Bloomberg, Lipper-Refinitiv, SPGlobal, and Thomson-Reuters. Others such as MSCI are considered rating agencies that actively sell their data, which drives higher management fees for ESG centric funds, as run by fund managers such as BlackRock. This setup has worked exceptionally well for BlackRock, whose stock has grown from $324.77 at the end of 2016 to $669.12 at the end of the first quarter 2023. This pales to the capital gains enjoyed by MSCI with stock increasing from $73.93 to $559.69 during the period. A good green deal for Wall Street!
MSCI describes its process: “An MSCI ESG Rating is designed to measure a company’s resilience to long-term industry material environmental, social and governance (ESG) risks. They use a rules-based methodology to identify industry leaders and laggards according to their exposure to ESG risks and how well they manage those risks relative to peers. MSCI’s ESG Industry Materiality Map provides a framework for key E, S & G issues by GICS® sub-industry or sector and their contribution to companies' ESG Ratings. MSCI assigns percentage weights to each ESG risk, according to their assessment of their time horizon and impact. The ESG scores are then combined and normalized relative to industry peers to achieve the overall ESG rating. MSCI ESG Ratings range from leader (AAA, AA), average (A, BBB, BB) to laggard (B, CCC).”
Notice anything about actual benefit to the environment or society? Nope – it's just word salad.
Other rating agencies have different methodologies, which will generate different results. When there are multiple “standards”, there no real standards. Companies are instead rated against their competition, perhaps using the robust algorithm a quant nerd can derive. Coca-Cola may be graded as less bad than PepsiCo, as if their sugar laden drinks are perceived to cause less diabetes risk. This scheme also helps sell consultancy contracts to woke management and the fearful non-woke. “Non-woke” management can easily get swept into the process as it does not wish the negative publicity of appearing out of step with the Woke’s loudest and most impatient voices.
What are the Risks to Your Retirement?
The most significant risk derives from the Department of Labor rule of November 22, 2022.
The rule assumes that ESG investments provide potential financial benefits that can be taken into consideration during fiduciary decision making. The evidence of tangible results is less than skimpy.
Moreover, investment managers can satisfy their fiduciary responsibilities by reference to purported ESG benefits, without a requirement to provide supporting verification of their value. Similar criteria were enacted for shareholder proxy voting.
The “tiebreaker” standard set by the Trump Administration required competing investments to be economically indistinguishable before collateral factors could be brought to bear. The new rule effectively stripped this requirement.
Finally, the rule that fiduciaries do not violate their responsibilities if they provide options believed to popular with participants. It is assumed the public will more greatly participate with this rule.
This provides any cover that any investment manager could ever want to provide a less than economically prudent course. This rewrites the both the fiduciary and suitability standards. The public can then be given what investment management believes they want, rather than what is truly financially responsible. This could eliminate all sorts of regulatory and civil liabilities. "We The People" will become "The Wee People."
With ESG scoring schemes all over the map, do we really expect any of the rating agencies to be able to prove they have helped drive the results they aim for? A company’s scores will be different among agencies, providing management an opportunity to put its “best” ratings forward. This will make good tangible financial results even tougher to achieve for the public.
In a recent article, The Federalist’s Helen Raleigh cites Sanjai Bhagat’s work citing companies using their adoption of ESG as a cover for poor financial performance. Moreover, Bhagat notes many companies in ESG portfolios had worse compliance records than non-ESG companies, then failed to improve compliance with labor and environmental regulations. So much for “doing good” for those who invest to “feel good”.
What’s at Stake
The financial impact of an investment shortfall will adversely affect your financial flexibility in retirement, as will higher fees to the ESG scorekeepers.
• The result is another “hidden tax” to pay for the Green New Deal, as if the higher pump prices and heating bills are not enough. No one has presented the true cost of transitioning to renewables from fossil fuels. We can probably all guess why not.
Those managing retirement monies for us ideally operate as fiduciaries, who put the best interests of their customers above everything else. The social and climate justice warriors WILL put their agendas ahead of their customers. Moreover, they use their power for shareholder voting to increase their sway with management.
The ESG evaluation process is far from “time tested”, or even “back tested”, to determine if the scoring approaches are effective in measuring the desired outcomes.
In a perverse way, the Radical Left may claim ESG investing helps protect Medicare and Social Security trust funds. The public will delay retirement, which will keep us paying FICA taxes longer, delaying the time when the fund balances turn negative.
The Red States Push Back
Florida, Texas, West Virginia state governments are taking their own actions to discourage, and in some cases, deny investment decisions made utilizing ESG scores.
Florida now prohibits the state’s pension fund managers from using ESG criteria when making investment decisions. The state has recovered its proxy voting rights, which permits Florida to vote their shares as it wishes, rather than as the fund manager wishes. Texas and West Virginia, as producers of carbon fuels, have ceased business with financial firms that do not invest in energy companies.
Similar legislation was introduced in the Michigan House of Representatives this past week (House Bill 4381), but with Democrats in the majority, the bill has no realistic chance of passage.
Nineteen state governors have signed a group statement looking to leverage state pension funds to focus on companies maximizing shareholder value, rather than proliferation of woke ideology. Moreover, efforts would be made to protect citizens from financial institutions using ESG influences such as “social credit scores” in providing financial services.
This has been backed up by 21 state attorneys general. Fifty-three large financial institutions were warned to follow their fiduciary obligations under various state laws to maximize investment returns.
Moreover, individual investors are beginning to catch on to the weaknesses of this investment approach. The fourth quarter of 2022 showed $6.2B in net outflows for US sustainable funds. Perhaps no definable benchmarks or standards, higher fees, and results that can be replicated elsewhere do matter.
Note: This column is presented solely for informational and entertainment purposes and is not to be construed as financial or investment advice.
• Select investments based on financial prospects. If your employer does not offer non-ESG funds, take your complaints to Human Resources, Finance, and Legal. Talk to your coworkers. It's your retirement and should be invested in the most profitable manner possible, rather than simply wasted paying for a meaningless “ESG” label.
• Thank all our Michigan Republican congressional delegation for voting to nullify the DOL rule favoring ESG. Encourage another bite of the apple.
• Hold our Democrat state lawmakers accountable for failing to take up legislation to ensure that state funds are invested only in funds that exclusively prioritize return on investment rather than non-financial metrics.