ESG investing is certainly rapidly catching on in the United States; a trend that is highly likely to increase with the Biden administration identifying climate change as a crisis and placing tremendous overall emphasis on sustainability. Based on data from Morningstar, the $51.1 billion net flow into sustainable investing open-end mutual funds and ETFs during 2020 was by far a record, more than doubling 2019’s $21.4 billion and surpassing 2018’s $5.4 billion by nearly 10 times.
However, the flows are dominated by institutional investors, with only a bit more than 25% coming from retail or individual investors. Furthermore, according to the Plan Sponsor Council of America, just 3% of 401(k) plans offer an ESG fund option and such funds account for less than 1% of total 401(k) assets.
Navigating Department of Labor guidance in recent years has made adding an ESG option quite challenging, although some encouragement is found in its retirement plan investing rule, “Financial Factors in Selecting Plan Investments,” which went into effect in January of this year. The rule, without specifically mentioning ESG factors, requires fiduciaries to consider “pecuniary factors” when selecting plan investments. Such factors are those a fiduciary prudently expects “to have a material effect on the risk and/or return of an investment based on appropriate time horizons consistent with the plan’s investment objectives and the funding policy. . . .” The rule further permits a plan sponsor of a 401(k) or other participant-directed plan to include investment options that promote non-pecuniary factors as long as they are prudently considered and the investment option is not the plan’s qualified default investment alternative (the QDIA). Furthermore, we expect clarity and support for ESG will come from the Biden administration’s review announced in late January.
However, beyond these positive developments, for the 401(k) (and 403(b)) market to meet what is clearly investor demand and become part of the overall ESG trend, the full ESG investor experience must be considered in evaluating investment options, including both ESG outcomes and fiduciary concerns for risk and return.
Only then will these strategies be truly ‘sustainable’ in the user sense. In other words, for participants to maintain their ESG stance over the long-run and not divest prematurely (often at exactly the wrong time) because of performance issues or unexpected risk, ESG strategies cannot be blind to fiduciary considerations.
ESG explained
At its most basic level, ESG is a measurement or quantification of a company’s impact on social and environmental outcomes that are perceived desirable. To gauge this impact, a scoring methodology is typically employed that measures hundreds, if not thousands, of criteria across the environmental, social, and governance spectrums. In this sense, ESG is a systematic approach in that it measures the relative impact of every security and eliminates the potential for human subjectivity. However, these ESG criteria may not necessarily be pecuniary factors that are proximately related to a plan sponsor’s fiduciary goals such as the financial health or risk implications of its portfolios.
The first step on the path toward user sustainability when selecting ESG investment options for a 401(k) plan, then, is marrying the concept of systematic ESG with some measure of financial health. After all, it’s not all that unusual to see a stock score highly on ESG criteria but have weak profitability and a bad balance sheet. These stocks, although well-intentioned, tend to detract from the investor experience as they are commonly a source of poor performance. Instead, by combining the objective scoring criteria of ESG with a similar objective scoring criteria for the financial quality of a firm, the user experience is improved and performance better controlled. Research suggests financial quality measures that consider profitability, cash flow, and balance sheet criteria are a good complement to typical ESG criteria.
The second step is to recognize high-scoring ESG stocks tend to concentrate in certain sectors, countries, and regions which, left unchecked, can be a source of considerable active risk. For example, stocks in the financial sector have, on average, higher ESG scores than stocks in the energy sector. Similarly, stocks in Europe tend to have higher scores than stocks in the United States. Unless explicitly controlled, ESG portfolios can take significant mis-weights to these sectors and regions which amount to substantial active risk. Unbeknownst to most ESG investors, these mis-weights may carry unintended macroeconomic risks as well; among other sensitivities, the performance of financials are highly correlated to interest rate movements and energy stocks are sensitive to commodity price risks. To avoid the whipsaw of unwanted macroeconomic exposure and, again, improve the user experience, ESG portfolios must tightly control sector, country, and region biases.
Defined contribution plan sponsors seeking ESG investment options in addition to the QDIA must keep the end-user experience—their participants’ experience—in mind. It is the sponsor’s duty to fully understand the risk and return implications of ESG options. On their own, naïve ESG strategies can take you only halfway to your ESG objectives. ESG strategies that consider financial quality and prudent risk mitigation can offer a better participant experience and take you all the way there.
Michael Hunstad, Ph.D., is Head of Quantitative Strategies with Northern Trust Asset Management.
Michael Hunstad, Ph.D., is Chief Investment Officer, Global Equities & Executive Vice President with Northern Trust Asset Management.
