Does the DOL have it wrong? How Pensions Can Satisfy Their Fiduciary Duty And Still Invest Responsibly
Can you be a responsible investor and still live up to your duties as a fiduciary? Recent regulatory developments from the U.S. Department of Labor (DOL) would lead one to believe investors have to make a choice and if that choice involves non-pecuniary vehicles then such investments would be prohibited. The recent guidance gives financial risk and returns primacy over any other factors, such as ESG investing, and went so far as to recommend barring ESG considerations from investment decisions by pension funds. I believe the DOL has this wrong.
Responsible investing strategies don’t need to come at a cost. We believe investors can generate their desired return / risk attributes and in fact improve them by adhering to principles of responsible investing. What’s more, the DOL guidance may ultimately cost pensions money. As longer-term trends continue to favor the adoption of ESG factors in one’s investment process, we would expect the opportunity to generate better returns as a result of these asset flows to be meaningful.
I can understand why the DOL has initially taken this stance. We’ve done research over a 10-year period (whitepaper here) which revealed that ESG focused funds broadly underperformed market indices over this time-frame; some for portfolio construction reasons, others for cost reasons. But, to be fair, the same can be said for actively managed strategies over the same time period that tried to beat the market but failed to do so. This is not surprising. This period saw a stock market fueled by a decade of low interest rates and financial support from the central banks of the world. This environment favored large-cap, momentum based stocks and the performance of these passive index funds broadly outperformed active index funds.
The DOL’s stance is defendable looking at data in a rear view mirror. Let’s look forward: as a fiduciary, along with generating your target return, you ideally want to minimize negative outcomes. These mainly include both company-specific idiosyncratic risk and broader systemic risk. When it comes to idiosyncratic risk, the attributes that make companies score poorly when analyzing their environmental, social and governance factors represent potential risks to their financial well-being in the future. Those companies that shine under E, S and G spotlights often possess attributes that contribute to long-term positive financial outcomes when measured over multi-year periods.
This is in part because ESG isn’t a short-term fix for solving tomorrow’s business challenges. Rather it’s a philosophy on how you approach your multiple constituencies as a business – how you treat customers and employees; how you respect the environment; how you play within the communities where your business engages, and so on. Over the longer-term, all of these issues are likely to form the hallmark of companies that are or will become the great stewards for society. That stewardship will create an acceptance and recognition by their customers who then view them as a brand that they want to associate with and support, thus improving their financial performance.
Our research suggests that factoring in ESG criteria can produce idiosyncratic (or company/sector-specific) performance differences between the client’s ESG portfolio vs. the base case index (e.g., S&P 500 Index). While these differences in performance historically tend to be small, they often favor ESG issuers.
However, ESG portfolios have typically only considered single asset class, pro-cyclical equity risk. As a result, they are all exposed to similar systemic market risk such as P/E compression, volatile interest rates or currencies, large swings in the price of input goods – in short, all of the factors that tend to threaten stock valuations, particularly in market downturns.
There’s a bigger opportunity for potential outperformance if you consider multi-asset class enhancements to ESG portfolio construction that diminish systemic equity downside risk. In fact, we believe that portfolio construction is often the more important leg of the stool that investors should consider because systemic market risks are almost always more pronounced than company specific idiosyncratic risks across a diversified portfolio of stocks. To account for these types of systemic risks, ESG portfolios should have more diversification with programs that can perform well when the economies are growing but that offer downside protection when they are contracting.
Looking ahead, will the massive expected flows into companies with better ESG attributes drive more capital to these better behaviors on a go-forward basis and cause ESG portfolios to outperform the index? We think so.
One way our largest institutional investors can allocate more investment dollars in ways that solve some of our greatest environmental and social challenges is for us to make responsible investing more effective and more responsive to fiduciary mandates. This means evolving towards more sophisticated portfolio construction techniques that look beyond equities and incorporate more holistic views of risk mitigation that account for idiosyncratic as well as systemic market factors.
So when thinking about how to square the DOL guidance, think fiduciary first. But being a fiduciary can also go arm and arm with being responsible.
Click here to learn more about Welton’s ESG Advantage strategy.
Chief Executive Officer