DOL Proposed Rule Change Brings Awareness to Sustainable Investing

The current US Department of Labor (DOL) has a bone to pick with sustainable investing; what is now colloquially called Environmental, Social & Governance or ESG investing. On June 23, 2020 the DOL issued a proposed rule that would limit the use of investments that consider ESG factors in retirement plans subject to ERISA, such as 401k plans.

Myriad ESG considerations vary from investor-to-investor. They may include, for example: climate change, pollution, workplace safety, human rights, private prisons, executive compensation and board diversity. ESG investors also engage with company management to effect changes in corporate policies. And many may invest a portion of their portfolios in community investments, such as low-income housing. An excellent primer can be found on the website of The Forum for Sustainable and Responsible Investment (US/SIF.)  The United Nations has adopted 17 sustainable development goals that investors can support with ESG investments.

Who Does this Affect?

The statutory purpose of company plans is to prepare participants financially for retirement. This directive is aimed at plan sponsors and whether they can or should offer ESG funds in company plan lineups as an investment option for their employees.

The question of whether “socially responsible” or “values based” investing has more non-pecuniary (make the world a better place) benefits than pecuniary (reasonable risk-adjusted returns) benefits has been a focus of the DOL and its rule making, on and off, for years. The most recent proposal has been taken by the investment community as being particularly onerous and would possibly eliminate the ability of employers to offer their employees the choice to invest in ESG focused mutual funds.

Opposition to the proposal during the 30-day comment period – by investment professionals, policy professionals and individuals – has been overwhelming. With many comments pointing out that well-constructed portfolios taking ESG into account don’t need to sacrifice financial returns.

According to Morningstar, only about 4.5% of plans had at least one sustainable fund, and they made up, on average, 0.17% of a plan’s offerings. The DOL approach seems like a solution in search of a problem.

If your company doesn’t offer such a choice, it may be irrelevant to your retirement savings at the moment. Of course, there have been instances when employees have successfully advocated for inclusion of such options in their plans. And, when you leave employment, you can rollover your company account into an Individual Retirement Account (IRA) at a brokerage firm and have the option to invest sustainably, with hundreds of available choices. And you certainly can – and are encouraged to – augment your retirement savings by investing outside of your work related plan while you are still working.

This proposal may or may not be implemented. But it does remind us of the importance of being able to invest according to your values and what you need to consider as you embark on such a journey.

From Hippies to Hedge Funds

Beginning with deep ethical and religious roots, ESG investing has grown over the course of five decades from a cottage industry to a very serious undertaking. Morningstar has published a remarkable history of the progression.

As of publication of the biennial 2018 US/SIF Trends Report on US Sustainable, Responsible and Impact Investing, there was $12 trillion of professionally managed ESG assets around the globe. A figure which has no doubt grown in the last two years.

Still a Little Squishy

The E in ESG has dominated the conversation for many years, especially concerns around climate change and companies’ carbon footprints. But this year’s Coronavirus pandemic and protests calling for racial justice have renewed a focus on the S – social issues – such as employee safety and racial diversity in the workplace. Companies in industries unrelated to their core businesses have produced hand sanitizer, ventilators and masks to support the effort in combating the virus. All with an eye toward how a company’s reputation and bottom line may eventually be affected.

Asset managers and their analysts have been working diligently since the early days to tie ESG considerations to risk factors that companies face to their bottom lines and to financial performance.

ESG metrics are still evolving. Even in an era of financial accounting irregularities, it’s still easier to measure a company’s revenues and profits than its ESG score. There is not yet anything in ESG investing equivalent to the generally accepted accounting principles (GAAP) in financial reporting. There are multiple “ratings agencies” using different criteria and weighting the criteria differently from one another in their assessment of the extent companies in their investment universe are more – or less – highly rated on ESG criteria.

What About Performance?

Performance is a tricky thing. I wouldn’t recommend relying on a pitch that ESG investing is going to “outperform” to induce you into adopting an ESG strategy. There are touts all over the place right now about recent ESG performance, particularly in the areas of fossil-fuel-free and alternative energy portfolios. These performance attributes may or may not persist. So, your financial plan should be designed to succeed, regardless.

Here’s the thing about performance. Unless you are invested in exactly the same portfolio as the next guy or gal, your performance is going to be different. Your performance is either going to outperform or underperform (either by a lot or a little) over any given reporting period, depending on the difference in portfolio composition. And it’s impossible to know in advance, by how much or for how long.

You may have more or less in stocks vs. bonds. You may have more or less exposure to US vs. international stocks. You may own a concentrated portfolio of 25 stocks to represent that asset class as opposed to an index fund with 3,000 different stocks. Diversification could be either a benefit or a peril, depending on how smart or lucky you are in selecting those few stocks.

To avoid the risk of underperforming to an extent that you jeopardize achieving your goals, the key is to be as diversified as possible with your ESG portfolio, while still trying to achieve your sustainability objectives. Once you do that, all the other important things, like your saving and spending rates, tax management, discipline, etc. are going to dwarf by orders of magnitude – in achieving your financial goals – whether your small cap ESG fund underperforms or outperforms its benchmark index by a few basis points.

Should You Invest Sustainably?

Only you can answer this question for yourself.  Leaving aside the question of “outperformance” – perhaps you can’t bear the thought of owning companies that contribute to global warming or profit off of mass incarceration. If you answer yes to this question, our role as an advisor is to help you understand what’s involved, what the trade-offs might be and to help you figure out the most effective way to execute a sustainable investment strategy in the context of your financial plan.

There are now multiple tools to assist you with your sustainable investing. In 2016 Morningstar rolled out its Morningstar Sustainability Rating for mutual funds and ETFs. And just recently added an ESG screener. It is becoming increasingly possible to invest sustainably in broad index like portfolios.

As with any investment strategy, there is no guarantee that your expectations will be realized; financial or otherwise. But steps can be taken on both counts to increase the odds.

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