Update on Responsible Investing: Where Do Things Stand Now?
David Keto
Responsible, sustainable, or ESG investing has recently dropped out of the headlines despite efforts by culture warriors such as Leonard Leo to promote it as another battleground in the fight against liberal values.
Where do things stand now? And, based on where things stand, is responsible investing still a prudent strategy for institutional investors, like pensions, and for individuals?
Performance Update
Responsible or sustainable investing had a strong 2023 after a slower 2022.
According to a recent report of Morgan Stanley, “Sustainable Reality: Sustainable Funds Show Continued Outperformance and Positive Flows in 2023” citing Morningstar data:
Sustainable funds tracked by Morningstar outperformed their traditional peers in 2023 with a median return of 12.6% compared with traditional funds’ 8.6%.
These funds outperformed across all major regions and asset classes, including both equities and fixed income.
Investor demand for sustainable funds grew to $3.4 trillion, up 15% for 2022 and reaching 7.2% of AUM.
Even more important than year-by-year performance, long-term performance continued to be strong. $100 invested in December 2018 in sustainable funds grew to $135, on average, while in traditional funds $100 grew to only $125. A weaker 2022 was more than compensated for by superior performance in the other years.
Despite the long-term data, some people continue to labor under the false assumption that responsible investing, by definition, sacrifices performance in order to take into account non-financial considerations in investment decision-making. This is certainly the line being pushed by the “anti-woke capitalism” crowd led by Leo in a PR campaign funded in substantial part by fossil fuel interests worried about divestment and their access to capital.
However, a majority of the investment industry sees things differently. In a recent survey conducted by Morningstar, 67% of asset owners believe that ESG factors are material to investment performance. Note that this survey covered the entire industry, not just responsible fund managers.
Consider the specific case of fossil fuel investments. Anti-ESG advocates have pointed to missed opportunities for sustainable funds that exclude fossil fuel stocks to capture the bump in fossil fuel company values following Russia’s invasion of Ukraine and the disruption in the global energy market. But the longer-term picture is quite different, even taking into account that bump. Over the past ten years, the S&P 500 index has delivered a healthy total annualized return of 12.56%. Over the same period, the energy sector of the S&P 500 index, still dominated by fossil fuel companies, has delivered a total annualized return of just 4.54%, including the Ukraine-war-driven price jump. (Data from the S&P Global website based on index values as of April 25, 2024.) Long-term investors like pensions and retirement savers who divested ten years ago, made the right decision from an investment perspective. Will it continue to be the right decision? No one knows, of course, but there are strong reasons to think so.
Why Responsible Investing Makes Sense Financially as well as Ethically
One way to look at things is this: Environmental, social, and governance (ESG) factors highlight the externalities of unfettered market capitalism – environmental degradation, global warming, mistreatment of workers, human rights abuses in supply chains, discrimination in hiring and governance, and so on. These are ways in which some companies try to offload costs and harms onto third parties so that they don’t flow to the corporate bottom line.
The bet an asset manager is making in refusing to consider ESG factors in investment decision-making is that these companies will get away with it over the long term. Such managers are betting, for example, that bad-actor companies won’t be subject to regulatory enforcement or private legal action for pollution they cause. Fossil fuel companies won’t be stuck with stranded, worthless assets as the world shifts to clean energy. Abused workers won’t find redress through collective bargaining, lawsuits, and political action. Consumers won’t revolt over stories about abusive working conditions at offshore manufacturers. And so on. More fundamentally, these asset managers are betting that companies that cut corners in ways that damage innocent third parties or society as a whole don’t have broader and deeper management problems that will undermine long-term performance.
Further, the minority of asset managers who still choose to ignore ESG factors in investment decision-making are betting that ordinary investors don’t care about sustainable investing. It is rudimentary to investment strategy, in general, to place your investment bets where you think there is growing investment demand. A recent Morgan Stanley survey, reported in January, showed that more than half of individual investors plan to increase their allocation to sustainable investments in 2024 while 70% believe that strong ESG practices lead to higher returns. The “anti-woke capitalism crowd” are trying to sweep back this tide - and getting some currency in the media and political conversations - but their message isn’t reaching ordinary investors.
What are ETIs and Why are they Important?
It is worth spending a moment discussing economically targeted investments (ETIs) because they have been the mainstay of union-backed responsible investment funds going back decades.
In 1994, the US Department of Labor formally approved ETIs by ERISA-regulated retirement plans well before “ESG” was a widely recognized term. What is an ETI? According to the DOL, ETIs are investments that deliver economic benefits – particularly job creation – in addition to financial returns. The DOL allowed retirement plans to make ETIs if doing so would not discount anticipated risk-adjusted returns. Stated differently, a retirement plan in choosing among comparable investments from an anticipated risk-adjusted-return perspective, could take into account the collateral benefits of job creation or other non-return economic benefits in making a final investment decision. This is often referred to as the “all-things-being-equal test.” More recently, the DOL extended this basic analysis to ESG investments (after a temporary about-face under the Trump Administration).
ETI’s are typically private investments in job-creating projects – real estate, manufacturing facilities, and infrastructure. Classic labor-sponsored and labor-friendly ETI funds invest in housing and commercial real estate development by responsible contractors – i.e., contractors with union labor forces that pay union wages and benefits. In general, these funds have performed competitively with comparable real estate funds without any responsible contracting requirement.
In contrast, most, though certainly not all, ESG investing involves investments in publicly traded companies and securities. Does the concept of ESG embrace ETIs? Maybe. Both are forms of responsible investment. However, most descriptions of ESG factors – include the “S” or social category – do not include high quality job creation as an objective. For this reason, it is useful, particularly for investors of labor’s capital, to keep in mind ETIs as a distinct category of responsible investment.
