Investment-Oriented

Looking Ahead Responsibly

Experts anticipate the increasing importance of ESG for plan investors

Ask Adam Strauss, a portfolio manager at the Chicago-based Appleseed Fund, to describe the way he evaluates and selects investments, and he will give an answer similar to that of many active managers.

“We’re stock pickers, so what we’re looking for is to invest in high-quality companies with stocks that are significantly undervalued,” Strauss says. “And we look very closely at balance sheets. If a company experiences a temporary problem in the business but the balance sheet is strong, you’ve got lots of time on your side to turn things around. If it’s weak, then that’s working against you.”

It is only after discussing pricing power and competitive advantage that he brings up the term “sustainability” or “ESG,” short for environmental, social and governance. The term has become shorthand for investment methodologies that consider sustainability factors in assessing risk and return.

ESG considerations can involve anything from an investment’s carbon footprint to its sensitivity to potential resource or energy shortages. Other elements include investment chain alignment and active asset ownership.

Strauss says the Appleseed Fund incorporates ESG not only to ensure that shareholders own environmentally and socially responsible companies, but also as a means of eliminating risk and boosting potential returns.

“Our goal is to beat the market, so we’re very focused on delivering returns and doing it with less risk,” Strauss says. “We’ve beaten the markets by several percentage points per year since starting in 2006, and we’ve also delivered an extremely low beta.”

Interestingly, it is the traditional risk and return factors that will be most important for ESG funds, as they are for all funds, when it comes to penetrating the retirement planning marketplace. That is because the Department of Labor (DOL) has affirmed in a number of advisory publications—especially two issued in 2008 by its Employee Benefits Security Administration (EBSA)—that ESG factors must be considered secondarily to the economics of any investment being contemplated by a plan under the Employee Retirement Income Security Act (ERISA).

In other words, according to the DOL, noneconomic factors can serve at most as a tiebreaker when retirement plan fiduciaries are considering investment choices. That holds true even for plans at issue-dedicated nonprofits and other social organizations, where participants may be more willing to consider ethics during the investment process.

Despite this fiduciary hurdle, experts anticipate environmental factors—namely, climate risk, energy pricing and resource scarcity—to become significantly more important to retirement plan investors in the years ahead.

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From SRI to ESG

Responsible investing is more than a passing trend, according to a report issued by the Commonfund Institute last fall, titled “From SRI to ESG: Changing the World of Responsible Investing.” The report also noted that the U.S. responsible investing market was estimated to have $3.74 trillion in assets under management (AUM), representing 11.2% of the $33.3 trillion total assets under management in the U.S.

According to Christopher Rowe, a senior vice president at Prudential Investment Management in New York, ESG investing has evolved significantly in the last 20 to 30 years to focus on carbon, energy and sustainability.

Early portfolio screens, such as those used during the 1980s and 1990s to eliminate companies with ties to apartheid in South Africa, for instance, were very much values-oriented, Rowe says. Others screened out so-called “sin stocks,” passing over companies with ties to firearms, the military, gambling, pornography, alcohol and tobacco—a practice usually referred to as “socially responsible investing,” or SRI.

“The industry has evolved to have more to do with the framework of ESG—to think about those environmental, social and governance factors as they relate to the long-term economic attractiveness of a particular investment,” Rowe says. “So it’s really becoming more of an economic values discussion than a moral values discussion.”

Current environmental screens reflect this sensibility and include the carbon intensity of a company’s operations, Rowe says, as well as sensitivity to water shortages and spikes in energy or raw materials prices resulting from climate change and an expanding global population.

Rowe and Strauss are quick to add that such environmental factors are only the first half of the story when it comes to ESG investing. Also of critical importance is the determination around whether climate risks are actually relevant to a particular investment decision.

“If we are holding an equity on average [for] a year and a half, is long-term water scarcity going to impact the potential performance of that company? It may not,” Rowe observes.

He says one area where ESG is starting to dominate decisionmaking is in real estate portfolios, which are frequently managed for large institutional defined benefit (DB) plans.

“We’ve done retrofits in the buildings we own, along with efficiency improvements and waste improvements,” Rowe says. “Through that, we’ve been able to improve the value of those real estate assets. It’s environmental as well as economic.”

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Short Term vs. Long

It is simple enough to discount climate risks when holding a security for a year or less. More challenging is assessing the materiality of ESG factors within a long-term context, for example as part of retirement planning. In this space, many firms offer target-date portfolio options that stretch to 2050 and beyond.

“As ESG managers, we think that, over the long term, those companies that are more efficient in the way they run their business, and that are developing products and services with appeal to sustainability-minded consumers, are going to perform better,” Strauss says. “If we look at all those things, and we think we’re buying the stock at the right price, we think our risk-adjusted returns for our investors are pretty good.”

Strauss says that despite a growing body of studies and academic papers attempting to show that ESG can reliably outperform other investment strategies, making the case to investors has been challenging.

“It’s a hard thing to demonstrate, and in my opinion, it hasn’t been demonstrated conclusively,” he says.

According to the Asset Owners Disclosure Project (AODP), which publishes an annual report on the state of ESG investing among the world’s largest asset holders, less than 2% of the more than $52 trillion managed by the world’s 1,000 largest pension funds is invested in low-carbon assets. Beyond large pensions, as much as 55% of all global investments are exposed to climate risk, according to the “AODP 2013–2014 Global Climate Index.”

Only five out of 1,000 funds surveyed achieved the report’s highest rating: AAA. A total of 27 asset owners scored an A rating or above, compared with 22 last year.

Notably, these groups saw no strong correlation between higher sustainability and lower returns. In fact, analysis of investment funds earning the survey’s highest rating shows that none of the most sustainably run pension, superannuation, insurance and sovereign wealth funds are near the bottom quartile of returns in their respective countries.

Those numbers should be enough to convince active managers of the materiality of climate risk, AODP researchers argue. Also important is that the risk attributes of climate change have a high likelihood of occurring across nearly all geographic locations and economics, they say.

Here is how John Hewson, AODP chairman, sums it up in a written introduction to this year’s report:

“Such is the sheer scale and potential reach of climate risk that any fund cannot claim to be looking after the long-term interests of its beneficiaries if it is not managing the components of climate risk. … Civil society, assisted by a hungry media fascinated as to how the world’s largest industry will manage its own redevelopment, will continue to create new pressure on laggard funds.”

Strauss points out another important fact about ESG management: “There’s this logic here that, if you screen out certain companies, then you don’t have access to the full universe and therefore you must underperform. But if you look at the reality of how most active managers work, they’re given a limited style box to work in. Most managers are pinned within a narrow box, and those limits are far more restrictive than the limits you may see as an ESG manager.”

ESG vs. Fiduciary Responsibility

When questions arise concerning fiduciary duty and environmental, social and governance (ESG) investing practices within qualified retirement plans, it can help to go straight to the source.

According to Bradford Campbell, counsel with Drinker Biddle & Reath LLP in Washington, D.C.,  and former head of the Employee Benefits Security Administration (EBSA), the Department of Labor (DOL)’s guiding interpretive bulletin on ESG investing within qualified retirement plans is 29 CFR [Code of Federal Regulations] 2509.08-1.

“The term that has been used historically by the Labor Department is ‘economically targeted investments,’ and that really dates back to the first foray the DOL made in this area, back in the Clinton administration,” Campbell explains. “That was the term in vogue to describe these things.” Campbell directed EBSA at the time the guidance was released.

“What we clarified in the 2008 guidance was, ‘When can those factors be considered?’” he says. “In a nutshell, we concluded that they are a reasonable tiebreaker. So in cases where you’ve done economic analysis and you find that you’ve got essentially equivalent investments in terms of the spot they’re filling in the portfolio of the plan, then you need to have some way to make a determination. At that point, it’s appropriate to consider issues beyond the pure economics of the investment.”

EBSA released a sister bulletin (08-2) during Campbell’s tenure, which deals with questions concerning when it is appropriate for retirement plan participants and sponsors to operate as “shareholder activists”—using plan assets to influence the way companies are managed.

“It gets into a similar analysis,” Campbell says. “In order to spend money to try to change the way companies are operating, you need to be sure [this will] have a clear economic benefit to the plan. Another goal here is to make sure that plans aren’t used as political tools by those who are running them.”

Campbell adds that he has seen little or no litigation on the particular point of fiduciary responsibility and ESG investing. He recalls an advisory opinion the DOL issued in 2005 following news reports that the AFL-CIO was urging some of its member unions to use qualified plan assets to advocate changes to Social Security.

“This was back during the debate over whether individual accounts would work for Social Security,” Campbell says. “This letter was essentially a reminder to those folks that you can’t do that. You can’t just do political advocacy using plan assets, because that’s not the purpose of a plan. That’s an example of a real-world issue where this comes up.”