The Department of Labor Attempts to Throttle ESG Investing

A Modest Proposal Last week, the Department of Labor proposed to restrict, if not outright eliminate, environmental, social, and governance (or ESG) investment practices.

The DOL oversees private-sector retirement schemes, meaning that its regulations apply to corporate pensions and 401(k) plans. Its mandates do not apply to retail investment accounts, nor to non-corporate institutional portfolios, such as Yale’s endowment fund or the nation’s largest pension, CalPERs, which serves California’s public employees.

Thus, if the DOL’s proposal is approved, it would not destroy ESG investing in the United States. Nonetheless, the DOL supervises $9 trillion in assets--about 30% of the value of the U.S. stock market. That would be a painfully large marketplace for ESG managers to forgo. What’s more, the DOL’s action could conceivably spark similar measures by other regulators.

The DOL’s logic:

1. By ERISA law, fiduciaries are "required to act solely in the interest of the plan's participants and beneficiaries."
2. "Solely in the interest" means "solely in the financial interest." Arguments that ESG investing improves the general welfare are moot, as are claims that the plan's beneficiaries would wish for such an investment approach. All that matters are the dollars and cents.
3. Since ESG investing considers more than dollars and cents, it fails ERISA's standard.

Isn't It Ironic? The final item, that ESG investing considers aspects besides profits, is the DOL's dagger. It is also deeply ironic. As I wrote last month, a key difference between ESG and its predecessor, "socially conscious investing," is that socially conscious managers implicitly admitted that their strategies might reduce their returns, while ESG investors do not. Socially conscious investors used negative screens to eliminate stocks that violated their beliefs. In contrast, ESG investors seek positive attributes, which they claim will make their companies better investments.

For example, ESG investors obviously expect the third part of their acronym, governance, to improve their portfolios’ performance. Their environmental and social concerns less clearly reflect self-interest, but ESG managers maintain that environmental and social concerns pose material risks that investors must consider, and that companies that manage such risks well will make their businesses more sustainable. At worst, they won’t hurt.

Asserts Morningstar's Jon Hale, who follows the ESG marketplace closely, "I don't know of a single case ever where plan fiduciaries have selected ESG investments they believe would underperform." No lawsuits have alleged such an event.

As worded, the DOL’s proposal raises the following question. If an ESG manager modifies its marketing language, can it wriggle free of the DOL’s constraints? Would it be legally protected if it removes all suggestions of making the world cleaner, or improving community relationships, and instead couches its ESG policies as being adopted solely from self-interest, so that it can outperform its competitors over the long term by owning companies that are more sustainable?

Clear and Present Danger Uncertain. What is abundantly clear is the danger of selecting ESG investors who openly confess to being do-gooders. Per the proposal: "It is unlawful for a fiduciary to sacrifice return or accept additional risk to promote a public policy, political, or any other non-pecuniary goal." Rarely are regulators so direct. (Although, says Hale, their directness is misplaced, because no ESG investor knowingly does that.)

In such cases, the burden of proof would appear to be firmly on the side of the corporation. The proposal suggests that, were a company to use an ESG investment that promised non-pecuniary benefits (to use the department's term), it would need to demonstrate that the investment was outright superior to "available alternative investments." Being only among the best would be insufficient. "The Department expects that true ties rarely, if ever, occur."

That is a very high standard. If an ESG investment were to perform poorly after its selection--lawsuits tend not to be filed against winners--the company would need to demonstrate not just that its choice had an attractive track record and had been well researched, but was better than any alternative that the prosecution could suggest. No other form of active management so harshly judged.

Thus, I am skeptical that ESG investing will persist under ERISA if this proposal passes in its current form, unless (as previously mentioned) ESG providers can skirt the rule by altering their language. The DOL suggests that 401(k) sponsors may be able to add ESG funds as secondary options to plans that already have full lineups, but pension plans lack that escape route. At the least, their waters have been thoroughly muddied.

The DOL expects its proposal to deliver the following benefits:

Some fiduciaries will select investments that are different from those they would have selected pre-rule. These selected investments' returns will generally tend to be higher over the long run. Also, as plans invest less in actively managed ESGs, they may instead select mutual funds with lower fees or passive index funds.

The DOL foresees two outcomes. First, some fiduciaries will swap actively managed ESG investments for conventional active funds, which will improve their performances, since (per the DOL’s stance) conventional active funds seek only the best possible returns, while ESG funds have additional goals. The DOL offers no proof for this contention, because none can be had.

The second implication is that corporate plans will profit by switching from actively run ESG investments to lower-cost indexers. That may be true. But once again, the same logic would seem to apply to all actively managed investments. This book, after all, has been written. We know that active managers of all stripes, both retail and institution, tend to lag index funds. It is strange that the DOL's counsel extends only to one flavor of active management, rather than the entire field.

Political Underpinnings Although I have emphasized this proposal's practical outcome, rather than its roots, I would be amiss if I didn't not mention that the announcement is politically motivated. Democratic presidential administrations typically favor ESG investing, while Republican administrations do not. It is therefore unsurprising that 2020's DOL seeks to reverse some of the decisions that it made in 2015.

Besides partisan differences, the proposal also involves a tussle between government and the marketplace. As Bloomberg's Matt Levine points out, each of those two sides thinks that it is best positioned to make such decisions. "Under Donald Trump," writes Levine, the U.S. government says "coal is great, more coal please," while BlackRock (being an ESG investor) responds "coal is bad, no more coal please." Levine continues, "The people making environmental, social, and governance issues should be the government, says the government; the asset managers and pension funds had better stick to making money."

Perhaps the problem is that if each administration undoes the work of its predecessor, regulatory guidance will constantly shift. The outcome would be steadier if the marketplace were to take the lead.

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.