Department of Labor’s Rule Change Shows ESG Funds Have Staying Power

Last week, the U.S. Department of Labor (DOL) announced it was rescinding a rule dating from the Donald Trump administration that ended up preventing retirement plan administrators from considering climate change and other ESG (environmental, social and governance) factors when deciding upon 401(k) and other retirement plans. A boon for ESG funds could soon follow.

According to at least one analyst, not only are such managers now allowed to weigh ESG as a factor in selecting funds, but it could also become their fiduciary duty to do so. The rule change could also permit ESG investing to become available to more than 100 million workers, as stated in an emailed statement from the nonprofit Ceres.

The DOL’s decision comes in the wake of a May executive order that instructed the entire federal government to deploy policies designed to safeguard businesses, workers and families from climate-change related financial risks.

To be clear, the Trump White House did not outright ban ESG investing within employee retirement plans. But what the rule did accomplish, said many critics of the policy, was deter companies from offering more sustainable financial products such as ESG-indexed funds on the menu of retirement options in order to prevent any potential litigation from employees. According to Nasdaq, at last count less than 3 percent of company retirement plans include any form of ESG-indexed or socially conscious funds.

Advocates of socially conscious investing said such decisions on the role ESG funds could have in helping workers plan for retirement have been shortsighted.

Overall, 2020 was a banner year for ESG funds, as many performed better than the equity markets at large. Meanwhile, these same funds witnessed record inflows, as shown by recent data released by Morningstar. 2021 so far has shown mixed results depending on the source cited. One year’s bull can be another year’s flatline or, in the worst case, a bear market. One analyst at Bloomberg sneered at the idea, saying more ESG funds have underperformed than over-performed the rest of the market so far this year.

But investors looking at the long term, particularly those saving for retirement, understand that a year of growth can follow with a year of hard knocks, but that’s the market. 401(k) and IRA investments, if managed well, can result in a secure retirement and help families build intergenerational wealth. It's just that now, investors want to make sure their dollars are tied to companies that aren't disastrous when it comes to the environment, protect workers and have fair hiring practices.

In any event, investors are increasingly buying into planning their retirements through an ESG lens. A Kiplinger-Domini poll released last week showed that 70 percent of investors say a company’s ESG performance is very or somewhat important when they make long-term financial decisions. Four in 10 say they’ve bought ESG-indexed stocks or funds, two-thirds of millennials have made such investments, and overall 8 in 10 believe they will add ESG investments to their portfolios during the next year or two. And more than half of investors say the recent news about the environment and climate change risks are what is primarily driving such decisions.

Another report from RBC Global Asset Management, also issued last week, found a similar sentiment from investors worldwide. Around 40 percent of investors aren’t satisfied with the range of ESG funds currently available to them and seek even more options. Any stubborn beliefs that sustainability means an inferior investment have largely dissipated: More than 80 percent of these investors believe ESG funds can do just as well, if not better, than indexed funds overall — and over 70 percent said they use ESG principles to help guide long-term financial decisions.

To be clear, the decision to invest in ESG funds involves more research than simply funneling one’s money into a fund that has “ESG” in its title. There are criticisms, which are fair, that reiterate that a company can be completely transparent about its performance, while being a major polluter or saboteur of human rights, and still be included within an ESG-indexed fund. On the flip side, a company may perform well on the environment, internal governance or the socially conscious spectrum, but if their ESG-related disclosures are lacking, they could be overlooked by institutional investors.

Further, one of the most publicized tactics used to further sustainable investment — divestment from fossil fuels and other carbon-heavy industries — is not necessarily a rock-solid strategy, Bloomberg’s Mark Gilbert recently argued. Assets shed by institutional investors can simply be snatched up by hedge funds, with those dollars benefitting both energy companies and fund managers alike. Gilbert and other analysts suggest strategies that rely more on engagement with such businesses rather than divestment. The retort from some institutional investors, such as Green Century Funds, is that such stakeholder engagement is simply “too little, too late.”

Confused? Well, as is the case with our life choices and buying habits, there is no watertight strategy in making ethical and responsible long-term investment choices: We simply have to make the best possible decisions on selecting ESG funds and similar financial products using the best possible information (and time) that we have at hand.

Hence Debbie Carlson of MarketWatch suggests an eight-point plan for sustainable investing, which includes researching the fund’s prospectus to see if that ESG fund has been “rebranded” from what was once an underperforming fund. Learning the background of the fund’s manager and philosophy toward investing can also help the uninitiated investor make the best possible financial decisions.

The Joe Biden administration’s stance on climate action is a welcome U-turn to supporters of sustainable investing who had been disheartened by the previous regime in the White House. Policymaking by executive order, however, has its disadvantages. Even though the frequency of executive orders in recent decades is far lower than it was during the first half of the 20th century, the reality is that there is a chance many of these directives could disappear come 2025 or 2029.

Nevertheless, the events of the past few years show ESG investing is no longer fringe and is now fact mainstream. Similar to what we’re seeing in the labor markets, Americans appear ready to expect more from the financial markets. “…the vast majority of Americans, regardless of political ideology, want companies to prioritize the same issues: paying a living wage, providing good jobs, cultivating a strong, diverse and inclusive workforce, and protecting workplace health and safety,” said Just Capital in a recent public statement. “The DOL’s new proposal is one way of helping drive capital to the companies leading on these and other important issues, and, if approved, we look forward to seeing its impact in practice.”

Image credit: Joshua Mayo via Unsplash