Proposed ESG rules for pension funds won’t change much

The battle lines are being drawn over the Department of Labor’s proposed changes to the rules for ESG investing for pension funds and other retirement funds. Some argue that investing in companies with an environmental, social or governance focus can positively benefit investment returns, while others claim that ESG investing can hurt returns.

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Minor change in ESG rule for pension funds

The proposed rules do not block pension funds from investing with ESG considerations in mind, but they do require that such investments be more transparent. An opinion piece from Aaron Brown on Bloomberg notes that the DoL's rules have always allowed retirement funds to consider ESG factors when selecting investments. The key focus of the proposed rule is to ensure that such decisions aren't made at the expense of investment performance.

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The rule does address one issue with ESG investments by pension funds, which is that most such investments violate accepted investing principles. This results in lower investment returns and portfolios that have worse ESG scores than index portfolios, according to Brown.

If the new rule is put into place, pension and other retirement funds will have to document that they look at ESG issues from the perspective of modern portfolio theory instead of older, incorrect approaches.

How modern portfolio theory plays a role

Traditional ESG approaches start with things that the investor doesn't like, such as carbon emissions, cigarettes or excessive compensation for executives. Funds avoid companies that have the worst scores on those issues and then choose from among the companies that are left.

In modern portfolio theory, reducing the stocks from which you're going to choose must reduce your risk-adjusted return as well. The theory requires reducing the weighting on companies you don't like, whether for ESG reasons or due to expected returns, but the weight doesn't fall to zero.

The theory would also emphasize expanding the investment universe to include more companies with good ESG scores. The idea is that expanding into companies with good ESG scores improves ESG at least as much as avoiding companies with bad scores while also improving risk-adjusted returns.

Brown explains that avoiding the companies with the worst ESG scores while increasing weights of all the other companies causes the portfolio to be very unbalanced. Adjusting by boosting the weights of companies correlated with those that have been excluded usually brings in other companies with bad ESG scores, although perhaps not as bad as the companies that have been excluding.

As a result, the portfolio has a worse overall ESG score. To maximize the portfolio's ESG score, modern portfolio theory suggests that investors not exclude the companies with the worst ESG scores, but rather, those with the worse ESG scores relative to the amount of diversification they provide.

Returns are also lower because excluding companies for their ESG scores results is meant to reduce their share price, increasing their cost of capital and decreasing how much business they do. But by forcing down the price, you lose money by getting that lower price. The higher cost of capital also results in a higher return for investors, which means that by avoiding such companies, you miss out on better returns.

How pension funds will have to deal with ESG factors

In the Bloomberg piece, Brown argues that the proposed DoL rules will require ESG investments to "enter portfolios through the front door of MPT professional investment analysis rather than the back door of smiting evil." Pension fund managers will have to document that the factors they have chosen result in improved risk-adjusted returns or at least risk-adjusted returns that are no worse than if they didn't use ESG factors.

The Institute for Pension Fund Integrity applauds the proposed DoL rule, and a number of advisory board members submitted comment letters about it. They back the proposed rule because it would require pension funds to base their investment decisions entirely on financial considerations instead of ESG factors or other agendas.

In an opinion piece for Forbes, IPFI President Christopher Burnham said his concern is that he is concerned that "the people who are investing on behalf of millions of current and future retirees aren't living up to their fiduciary responsibility by choosing stocks and bonds on the basis of ideological or social preferences."

IPFI member Ken Blackwell said pension fund managers must remember they are "acting on behalf of individuals who sacrificed a portion of their wages every payday with the expectation that their money would be handled with care, not used to promote the interests of political actors."