Labor Department proposed rule to crack down ESG

Labor Department proposed rule to crack down ESG

In June 2020, the labor department proposed a rule that would govern how $10.7 trillion would be invested in private pension plans. These restrictions were brought forth by the labor department despite peaked interest in ESG investing and sustainably screened funds. According to the Wall Street Journal (WSJ), the labor department believes that ESG funds are not in the best financial interest of the American worker. This was derived from Labor Secretary Eugene Scalia’s statement as follows: “private-employer sponsored retirement plans are not vehicles for furthering social goals or policy objectives that are not in the financial interest of the plan. rather, ERISA plans should be managed with an unwavering focus on a single, very important social goal: providing for the retirement security of American Workers.”

The goal of a financial advisor acting as a fiduciary has always been to invest in the client’s best interest, especially in regard to retirement security. This proposed rule is based on the faulty premise that ESG investing is a facade of political figures and subjective interests fixated on personal agendas. The rumor holds that investments are being directed to companies that score high on ESG ratings and avoiding worse ones. This then plays into the theory that investing sustainably foregoes returns, which has been proven countless times to be inaccurate and that sustainable funds outperform non-sustainable funds.

From 2014-2019, sustainable funds did well in both up and down markets when compared to their conventional peers. “When markets were flat (2015) or down (2018), the returns of 57% and 63% of sustainable funds placed in the top half of their categories. When markets were up in 2016, 2017, and 2019, the returns of 55%, 54%, and 65% of sustainable funds placed in the top half of their categories.” We then saw a record 75% of sustainable equity funds rank in the top halves of their Morningstar categories.

From historical data and current research on the ESG Strategy, I would conclude that the retirement security of the American Worker is best invested in sustainably screened funds that not only look at the balance sheet of a company or charts and graphs but also the social, environmental and governance processes of an organization.

Rationality

The Department of Labor fails to make a rational connection between the researched facts and the proposed rule. My assumption is that if the DOL wanted to understand ESG material, they might have consulted the Sustainable Accounting Standards Board (SASB) Materiality Map. The SASB identifies sustainable areas that are likely to affect the financial performance of an industry. This would have provided insight into how exactly these investments are determined for use in the investment process.

Results are a function of the input data. Some of the ESG data includes engagement activity while others do not, but how an investment manager uses this data is what matters. If an investor wanted to invest in a fossil fuel company, an ESG mandate would not necessarily preclude that kind of investment if the fossil fuel company was working to improve their processes and reduce their environmental impact.

In an article published by the WSJ, Scalia stated that “Researchers … analyzed the methods of six different ESG rating providers and found that their approaches—and results—diverged significantly. In a comparison of two providers’ rating systems, Research Affiliates found a wide gap in the same companies’ scores. Facebook received a top environmental score from one provider and below-average from the other.” This is prime example of how research is used differently and for different purposes. Again, results are a direct function of the data input.

ESG ratings provide an overview of a company’s operational performance and ensure that companies are considering all material issues that could potentially affect the value of their organization. It is not a social agenda of tree-hugging activists but rather, a strategy that factors into consideration the impact of material, environmental and social risks that enhances risk-adjusted returns.

Mr. Scalia claims that the Department of Labor’s rule reinforces pension funds fiduciary duties and defends the limit on ESG funds by stating that “the department’s proposed rule reminds plan providers that it is unlawful to sacrifice returns, or accept additional risk, through investments intended to promote a social or political end.” The goal of ESG investments, however, is not to increase risk but to mitigate it, and through historical data, we have seen that ESG funds outperform wider markets over 10 years notching excess returns up to 1.83%.

The Organizational Microscope: ESG Screening

Scalia further discussed the goal of ESG screening guidelines by stating “sometimes, ESG factors will bear on an investment’s value … if a factory is leaching toxic chemicals into groundwater, lawsuits and regulatory action are likely to follow, sapping profits. A corporation with dysfunctional management will also typically be a poor investment”

This statement makes clear what ESG guidelines focus on. Why would any investor, or more importantly a fiduciary, not use all information available to help mitigate the probability of losses in the event of a crisis? Especially since ESG data recognizes issues such as equal pay, equal representation on boards, and ecosystem degradation.

The world has changed. This is no longer the Milton Friedman era of economics. The emergence of social media and headline risks have amplified the fact that we can no longer ignore the ESG issues that companies face. ESG issues are global in nature and directly impact performance and long-term value.

I personally do not know of a case where fiduciaries have selected funds that underperform, have high fees and low returns, or undermined financial returns to push a social, environmental or governance cause. We first witnessed the attack on shareholder resolution that the SEC tried limiting and now we see an effort to limit investments that have proven to aid investors in better decision making. It appears that they are trying to preserve an old economic system.

Any opinions expressed in this forum are not the opinion or view of American Portfolios Financial Services, Inc. (APFS) or American Portfolios Advisors, Inc.(APA) and have not been reviewed by the firm for completeness or accuracy. These opinions are subject to change at any time without notice. Any comments or postings are provided for informational purposes only and do not constitute an offer or a recommendation to buy or sell securities or other financial instruments. Readers should conduct their own review and exercise judgment prior to investing. Investments are not guaranteed, involve risk and may result in a loss of principal. Past performance does not guarantee future results.

Securities offered through American Portfolios Financial Services, Inc.(APFS) Member FINRA/SIPC. Investment Advisory Services offered through AJF Financial Services a SEC Registered Investment Advisor which is not affiliated with APFS.

Sustainability at AJF Financial Services

Sustainability is at the core of everything we do on behalf of our clients. Please click below to learn more about what sustainability means to AJF Financial Services

Check the background of your financial professional on FINRA's BrokerCheck.

The content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. Please consult legal or tax professionals for specific information regarding your individual situation. Some of this material was developed and produced by Advisor Launchpad to provide information on a topic that may be of interest. Advisor Launchpad is not affiliated with the named representative, broker-dealer, state- or SEC-registered investment advisory firm. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.

*Securities offered through American Portfolios Financial Services, Inc. (APFS) Member FINRA/SIPC. Investment Advisory Services offered through AJF Financial Services Inc. an SEC Registered Investment Advisor which is not affiliated with APFS.