Brian Croce of Pensions & Investments recently reported on a new ISS study. As reported, the study establishes a link between a high/favorable ISS ESG rating and profitability. Similarly, companies with higher ESG ratings are less volatile. The Department of Labor, rather rightly, in Field Assistance Bulletin 2018-01, cautioned fiduciaries against making too many assumptions or wishful thinking in establishing a nexus between an ESG risk factor and investment performance. The ISS study is worthwhile because it helps build a case for fiduciaries that use integration as an ESG strategy. As a reminder, integration is when one “incorporates ESG-related data and/or information in respect of an ESG factor into the usual process when making an investment decision where such data or information is material to investment performance and where the exclusive purpose is to enhance portfolio return or reduce portfolio risk.” See this glossary for more information and context.
"We believe a portfolio that focuses on sustainability and climate change will be a portfolio that outperforms," says Larry Fink. "The main component of the letter is saying this is going to be a great investment over the next 10 years, and it will also help the planet. pic.twitter.com/UVOGFZuN0I
— Squawk Box (@SquawkCNBC) January 14, 2020
As we prepare for upcoming proxy voting rules from the Department of Labor (DOL), it is important to consider their context. A registered investment adviser (RIA) can indeed satisfy its fiduciary duties under the Employee Retirement Income Security Act of 1974 (ERISA) to plan clients when taking environmental, social and governance (ESG) risks into account as part of investment decisions and voting proxies. Some will cheer the preceding sentence, while others remain skeptical. The fact is, with proper structuring, a fiduciary to an ERISA plan, or a governmental plan, for that matter, can favorably respond to client requests for ESG issues to be part of the investment mandate without losing much sleep over fiduciary duty risk.
For all the headline-grabbing that ESG garners, there remains considerable uncertainty over what exactly it means. This is unfortunate, not least because it is hard to comply with fiduciary duties if the conduct at issue is a moving target. ESG issues are various environmental (e.g., climate change), social (e.g., child labor) and governance (e.g., board structure) risk areas. RIAs can zoom in slightly and focus just on environmental, social or governance risks. Zoom in even further and focus on a single risk area, such as climate change.
From here, there are four primary techniques for addressing ESG risk. First, one can screen out from investment consideration those portfolio companies that fail to satisfy one more ESG risk-related criteria, known as negative screening. For convenience, divestment, can be included in this category because it is effectively screening out existing holdings. The second technique is to limit the investible universe to those best-in-class portfolio companies that satisfy ESG risk-related criteria, known as positive screening. Third, treating an ESG risk like any other material risk to investment performance, no more and no less. This is known as integration. The fourth technique is to address ESG risk through proxy voting and other forms of shareholder engagement.
At this stage, we now recognize that ESG is an umbrella term that encompasses myriad environmental, social and governance risks. We appreciate that ESG can be boiled down to discrete risk areas, such as cybersecurity or board diversity, and that RIAs can focus on only one of these risks as part of their mandate with a plan client. We also understand that there are basically four main ways of taking these risks into account in a similar plug-and-play fashion. Our final threshold question for fully appreciating ESG investing, and, ultimately, how an RIA can satisfy its fiduciary duties under ERISA, is the reason for addressing the ESG risk.
ERISA’s fiduciary duties can most directly be satisfied if the reason for addressing an ESG risk is to mitigate material investment risk or seek material investment return (i.e., alpha). At least for now, a less direct, though entirely attainable, path toward satisfying ERISA’s fiduciary duties exist when investment risk/return is at most a secondary reason for taking ESG into account.
An RIA’s motivation for treating one or more E, S or G issues as material is possible because, depending on the issue, there is now data linking that issue with portfolio return. Climate change modeling, for example, can predict the sectors, industries and asset classes most vulnerable to climate change, whether it is because their source materials dry up, they face high regulatory uncertainty, or some of their key assets become stranded. The DOL, in Interpretive Bulletin 2015-01, acknowledged that ESG can present material risks and opportunities for a fiduciary. By doing so, the DOL put ESG risk on equal footing with more traditional material market risks.
The significance of the DOL’s acknowledgment that ESG issues may in fact present material risks to portfolio performance cannot be overstated. An RIA, acting as an ERISA fiduciary, effectively treats the ESG risk as if it were any other material risk factor. Historically, though, a fiduciary considering an ESG investment had to satisfy the “tie-breaker” test, a set of conditions fraught with risk and more understandable in the abstract than in practice. This test, which remains in effect for ESG investments that do not treat ESG as being material to investment performance, demands that an ERISA fiduciary serve up the potential ESG investment opportunity and a non-ESG investment alternative with similar risk and return characteristics; only when the RIA determines that the ESG opportunity does not create more risk relative to return (and vice versa) than the non-ESG opportunity, may the ESG investment be pursued.
It is worth noting at this point that the DOL’s most recent guidance on ESG, Field Assistance Bulletin 2018-01, expressly reaffirmed the notion that ESG issues can present material risks (and opportunities) for plans, and, consequently, could be treated the same way as any other factors a fiduciary would consider as part of a prudent process. The DOL cautioned fiduciaries against making too many assumptions and against not relying on the evolving data linking one or more ESG issues with investment performance. This makes sense and should not present too much of an operational nuisance, considering that more fine-tuned data is available reportedly showing one or more ESG issues as being material to performance.
Proxy voting and other forms of shareholder engagement (which usually precede voting decisions) are one of the most popular techniques used to account for ESG risks. The exercise of shareholder rights is a fiduciary function under ERISA. It is critical that an investment management agreement be crystal clear as to whether the RIA is responsible for proxy voting, and that the RIA review the plan’s proxy voting policies when managing a separate account. Commingled funds may develop their own proxy voting/shareholder engagement policies, to which the subscribing plans would be subject.
Indeed, proxy voting and engagement rarely cost much, and proxy advisor firms are often used to reduce costs even more. Where, however, the exercise of shareholder rights would be expensive, such as in cases where it would be unusually expensive to partake in a shareholder vote, or where the time and preparation to meet with a company board is more involved, RIAs, as ERISA fiduciaries, should analyze and document the cost of that activity and weigh it against the expected gain. This is easier said than done. If anything, costs should be monitored and recorded in the RIA’s files, and there should be some estimate or calculation of what benefits will flow back to the plan investor over the short, medium and long term resulting from one or more votes or engagements.
Proxy voting and shareholder engagement have become a flashpoint and is under scrutiny by the Securities and Exchange Commission, the DOL and even the White House. Just this past April, the President issued an Executive Order that required the DOL, in part, to determine whether additional guidance on proxy voting was necessary. The Executive Order’s aim was on energy independence, so it is fair to assume that the White House is interested in whether more onerous requirements are necessary for ERISA fiduciaries to vote proxies on ESG issues.
Whether the DOL will impose on fiduciaries a more exacting and granular cost-benefit analysis for proxy voting and shareholder engagement remains to be seen. With that said, the DOL must walk the tight rope: if new guidance contains so many trap doors, thereby introducing significantly greater fiduciary risk for voting proxies and engaging the boards of energy companies, for example, then RIAs may feel compelled to purge fossil fuel companies altogether from the portfolio to satisfy their fiduciary duties under an ESG mandate. A tilt toward divesting or negative screening, and away from engagement and voting, arguably undermines the very purpose of the Executive Order. The DOL could update this guidance any day now.
Finally, several influential individuals and institutions have publicly stated that one or more ESG issues are in fact material risks. While there is by no means a consensus on whether ESG is material to investment performance, ERISA fiduciaries, at a minimum, would be expected to kick the tires on these claims. A prudent process necessarily involves some knowledge of what others are fiduciaries are considering. An RIA could take the position that these materials are already reflected in the share price; ERISA fiduciaries, after all, are not required to second-guess the market price of a security absent extraordinary circumstances. A fiduciary could alternatively believe that the markets do not (yet) fully appreciate these risks, thereby presenting meaningful opportunities from a risk/return standpoint for the RIA. Following this latter path, the RIA has various techniques at its disposal to addressing one or more ESG risks and, as described above, can satisfy its fiduciary duties under ERISA in doing so.
State Street Global Advisors (SSgA) recently released a research report entitled, “Into the Mainstream – ESG at the Tipping Point.“ It begins with a salient point: “ESG may well be becoming a mainstream trend, but every institutional investor – from pension funds to endowments to sovereign wealth funds – faces a unique mix of forces pushing them towards, or pulling them away from, ESG investing.” Indeed, asset owners and their managers are in fact subject to distinct standards of care, with ERISA’s fiduciary duties being the ultimate. In reviewing this report of global institutional investors’ reasons for addressing environmental, social and/or governance (ESG) factors in their investment decisions, and their reasons for not doing so, I considered the implications for ERISA fiduciaries, as “pension funds” were one of the institutional investors surveyed (along with endowments, charities, sovereign wealth funds and others). Consider also some of my prior analysis on the interplay of fiduciary duties under ERISA and ESG issues.
Here are the key takeaways:
- Fiduciary Duty: A Hurdle or Affirmative Duty to Incorporate ESG? A longstanding, significant obstacle to adoption of ESG by ERISA plans was whether it could be done in a manner consistent with ERISA’s fiduciary duties. The duty of prudence (Section 404(a)(1)(B)) has been the primary area of concern under an ERISA/ESG analysis, but duty of loyalty (Section 404(a)(1)(A)) and diversification (Section 404(a)(1)(C)) issues may also arise depending on the circumstances. Interestingly, the SSgA findings indicate that 46% of those surveyed viewed fiduciary duty as a push factor – i.e., an affirmative duty. If we drill down, the % of respondents who cited fiduciary duty as a lead push factor was highest in North America. If we drill down further, we see that, 41% of pension funds view ESG as a fiduciary duty. So, while pension funds seem less likely to view ESG as an affirmative fiduciary duty relative to other institutional investors, the fact that 41% do is notable. Again, this picks up pension funds globally and appears to cover private (i.e., ERISA) and public (i.e., governmental) plans.
- Risk Mitigation or Opportunity? The results also show that ESG risk mitigation is, at this point, (much) more of a basis/push factor to incorporate ESG factors into an investment decision than outperformance reasons (in North America, 42% (of all respondents – not just plans) cited risk mitigation vs. 1% who cited ESG as a way to generate higher returns). Various other studies make the point that ESG can present both mitigation and return opportunities, so it is interesting that institutional investors have gravitated toward mitigation rather than return. Perhaps lack of standardized disclosures and metrics is a reason, but it would seem that would affect both downside risk and return on any given investment. Perhaps another reason is that the outperformance takes longer to materialize. The DOL has reiterated that integration is examined under the regular prudence test and not the heightened tie-breaker test.
- Obstacles: A continuing theme, now picked up by this new SSgA report, is that the lack of standardized and transparent ESG data remains a primary obstacle to adoption (e.g., inconsistent scoring across the various providers). SSgA, in this report and over time, has helpfully examined the correlations of the major data providers in terms of a specific company’s ESG coverage. In one example, the ratings of companies by two prominent providers had a correlation of (only) .53. The lack of expertise in ESG was also cited as a top reason for not incorporating ESG factors – a valid reason for not making a particular investment under ERISA (fiduciaries are not expected to be all-knowing, but are expected to seek outside expertise when doing so would be prudent). Perhaps this explains why more and more ESG-related questions are showing up on questionnaires sent to investment managers.
- Governance: Respondents reported better measurement of governance (G) factors than environmental (E) or social (S) factors. For ERISA fiduciaries using integration, an analysis/documentation of how the respective E, S and/or G factor affects performance is important under DOL guidance. It is also important for investment managers and appointing fiduciaries to be clear on whether one or more E,S or G factors will be incorporated for any particular mandate, and to confirm that doing so would be in accordance with plan documents.