December 16, 2022

The White House has recently issued a regulation allowing investment fiduciaries, like 401(k) managers, to offer investment options “that consider environmental, social, and governance (ESG) issues, such as climate change and social justice initiatives,” Justin Haskins reports at Fox News.

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“Some workers may not notice any changes to their 401(k) and other retirement options over the next year or two,” he continues, “but others will soon find themselves stuck choosing between a short list of ESG-focused investment funds.”

The Biden administration insisting that “good investment decisions should take climate change and other ESG factors into account” creates a massive ethical problem for the financial industry.  A 401(k) manager would find incredible difficulty in both restricting plan participants to ESG offerings and acting as a fiduciary on participants’ behalf. 

For a retirement plan fiduciary, which funds are available in the plan and which are excluded often comes down to two basic factors — cost and performance.  As most 401(k) investors would certainly prioritize lower costs and better performance over a high social credit score, the 401(k) manager, as a fiduciary, has a responsibility to seek lower cost fund options that provide greater potential for return on investment.

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As an investment strategy, ESG fails on both fronts. 

The first is the higher cost of funds employing the strategy.  The cost of a mutual fund is often a function of the complexity of the fund’s management.  This is why a large cap index fund which does little more than hold the stocks of companies in the S&P 500 will cost very little to the investor looking to track the index’s performance.  An emerging market fund, which requires fund managers to relentlessly research and appraise the value of international stocks in lesser-developed nations for the greatest potential return, will often cost many times what the indexed fund does.

The management cost evaluation for ESG funds, however, is different.  They often hold, for example, domestic large cap stocks, which should signify lower management cost to investors.  But because there are additional administrative costs in analysts’ researching and measuring things like diversity of skin colors or genders among a particular company’s board of directors, the cost of investment necessarily climbs with ESG funds.

In the presence of increased cost, a fiduciary acting in the best interest of plan participants should be able to argue that greater potential performance offsets the additional cost.  But ESG doesn’t have a particularly strong track record, especially if you consider its forebears.      

Before ESG became the most recent popular marketing name for investment strategies which prioritized an investor’s feelings over cost and performance, there were “socially responsible” funds which restricted investment in oil companies, or cosmetic companies that tested on animals, etc.  Before that, back in the 1990s, a fund fact sheet might have enticed socially-minded investors by explaining that the fund’s objective was to limit investment in “sin stocks” like tobacco or gambling. 

The trend of the 1990s largely died out as a fad due to underperformance.  It was reinvented in the wake of global warming hysteria in the 2000s, but yet again, these funds were often terrible sellers due to lower performance.  And that is because these funds will typically not, except in some very specific circumstances, outperform funds that are not constrained by ESG considerations.