The attempts being made to expand the fiduciary obligations of pension fund trustees to incorporate ESG and, as yet, ill-defined ‘sustainability’ responsibilities are flawed and dangerous to the extent they weaken the obligation to maximise the financial interests of members.
Similar pressures on company managements need to be weighed against maximising shareholder value. CalPERS’ recent vote to oust an ESG advocate from its governing board illustrates what a sizeable group of pension plan members thinks is more important – being virtuous or protecting their future pensions.
ESG advocates, originally under the guise of ‘ethical’, then ‘socially responsible’ and ‘sustainable’, cannot have their cake and eat it, too. They can advocate investing for good causes and maximising financial performance but conflating the two is intellectually lazy, if not deliberately disingenuous. Virtue may come at a price.
Initially, ESG advocates simply argued that trustees of other people’s money – and company managers of shareholders’ money – had a responsibility to do ‘good’ as well as make money. This went beyond investing in accordance with national laws, which presumably reflect the public will, albeit sometimes imperfectly.
English law on fiduciary duty gives primacy to members’ financial interests, however, so this advocacy did not gain traction beyond a few genuinely religious or ‘ethically’ driven funds where members’ values were relatively well defined.
The ‘socially responsible’ advocates then claimed that taking ESG factors into account improved investment performance. It seems plausible that ‘good’ companies, somehow defined, would be less risky and may even be valued more highly. But it is very hard to establish a strong connection to positive expected returns. Indeed, starving ‘bad’ companies of capital should lead to reduced investment and higher expected returns in the starved sectors. Thus, achieving the desired reduction in ‘bad’ activity also implies a return sacrifice.
Like beauty, ESG is in the eye of the beholder. The ESG ratings currently published by leading research houses are not closely correlated, demonstrating that views of corporate ‘virtue’ differ significantly – even among professional researchers.
Empirical evidence to date, using data sets that are publicly available, suggests G is a rewarded investment factor but not when other common factors are already included. ESG factors are likely to correlate with other widely used factors, such as quality, thus adding little, if any, reward. E and S, if anything, have been shown to detract from returns.
It is difficult to argue against doing ‘good’. It’s like ‘motherhood and apple pie’ or, more topically, the impact of climate change. But the lack of widely accepted definitions of ESG factors and their relative importance to investment performance, let alone to people’s sense of what is ‘good’, is a recipe for confusion and capture of weak trustees by zealous sponsors and interest groups. Added to the significant resources required to identify, measure and exploit ESG factors, this may be prejudicial to members’ financial interests.
There is room for healthy argument about the extent to which trustees should pursue ‘good’ things and it is unconscionable to profit from doing ‘bad’ things, but the boundaries are hard to draw clearly in practice, notably in less developed countries. Trustees going beyond members’ financial interests must be sure they are reflecting their members’ non-financial interests, which is not a trivial matter to establish.
They need to know the costs of that pursuit and the extent of the financial risk it poses to members. Their founding beliefs should be honest about that. The approach of the New York City Employee Retirement System is to be applauded in seeking expert information about the likely financial impact of ‘decarbonising’ their portfolio so their members will be informed before such a decision is made. That is a prudent approach.
Active ownership and successful engagement with companies, whether on ESG or ordinary financial issues, is costly and risky. It requires influential stakes in companies, thus significant investment risk, or costly collaboration among shareholders and a lot of time and effort to change business practices. Passive-index investors, being ‘locked-in’ owners, should arguably take more responsibility when it comes to changing corporate behaviour, although that would raise their costs.
Active investment managers should only take account of ESG factors to the extent they improve their risk-adjusted return. If ESG factors are material to the way they generate superior returns, they would be failing if they didn’t reflect them in their process. But ESG factors are not unique in that regard. It is still active management – and finding winning strategies involves costly research.
Most managers emphasise some factors such as value, quality and momentum, to generate excess returns compared to a market-cap-weighted portfolio. They don’t have to use all known or suspected positive factors, however, only the ones they believe matter and can capture information cost-effectively. Conversely, it would be wasteful to require a manager to consider things that are not likely to improve their performance.
Sometimes doing ‘good’ comes together with maximising investment performance but it ‘aint necessarily so’. Those responsible for other people’s money should be clear about the cost and risk to members before embarking on an expensive pursuit of virtue or simply following the ESG herd. Managers touting ESG in their marketing should likewise be honest and careful about claims that performance benefits will flow. Virtue is its own reward after all.
Paul Bevin is the general manager, investments, of two New Zealand public superannuation funds, one of which has a statutory obligation to invest in a manner that is not prejudicial to New Zealand’s interests as a responsible member of the world community. That fund is a member of UNPRI, excludes certain investments and collaborates with peer investors to engage with companies potentially involved in ‘prejudicial’ activities. The views presented in this article are the author’s personal views.