401(k) Adviser: Understanding ESG investing and when it makes sense for you

The Department of Labor recently proposed a rule encouraging retirement plan sponsors to incorporate ESG criteria when selecting investment alternatives and voting company proxy statements.

ESG stands for "environmental, social and governance" and has become a catch-all for applying metrics and standards to investment choices that go beyond financial ones.

Historically, investing for good was known as "socially responsible" investing, and focused on restricting investment into industries deemed harmful to society such as tobacco, firearms, gambling and nuclear power.

ESG investing employs a broader definition of what it means to invest for good — delving into areas such as climate change, diversity, labor relations and corporate governance.

How can you participate?

The first challenge of investing for good is deciding what that means to you. After all, doing good with your financial resources is an extremely subjective undertaking. Religious-based and issue-based (i.e. climate, diversity, equality) investment strategies abound. The vast majority of these strategies are focused on picking the right stocks to own, but there are bond and balanced ESG strategies as well.

The least expensive — and often the best — approach to access ESG strategies is with an index fund. The most closely followed ESG index is probably the Dow Jones Sustainability World Index. Two of the most heavily invested indexes are the MSCI USA ESG Leaders Index and the FTSE4Good US Select Index. All securities included in these indexes are carefully screened for a variety of ESG criteria including workplace conditions, environmental impact, product safety, human rights and corporate responsibility.

Is ESG a better way to invest?

The performance of ESG strategies relative to the broad market is mixed, both in practice and within the academic literature. Practically, ESG strategies that focus on large-cap growth stocks like Microsoft, Alphabet and Amazon have generated substantial returns for investors recently. All three companies routinely score quite favorably in ESG metrics. Because of the heavy weighting in large-cap technology, the aforementioned index products have also shown competitive results versus the S&P 500 within the last three years.

It's important to ask, did these companies and portfolios outperform specifically because of ESG policies or for other reasons? It's hard to tell. Given that the industry is still deciding what ESG is and what ESG isn't, ardent proponents of ESG claiming performance superiority at this stage in the game look premature.

ESG strategies, by definition, limit investable opportunities based on criteria not related to profitability. Historically, strategies not focused on a company's bottom line have experienced opportunity costs. For instance, from April 2020 through mid-December 2021, the S&P oil & gas sector returned more than 90%, but companies in this sector are significantly under-invested by most ESG strategies. During this same period, most ESG index returns averaged closer to a 50% gain.

One very large bond manager has gone on record predicting the expected return for its ESG bond fund is 30 basis points lower per year versus its comparable flagship bond product that doesn't have an explicit ESG mandate. Perhaps the return differential won't change your decision, and that's your prerogative, yet the risk-reward tradeoff of ESG is important to consider.

Buyer beware

The asset management industry is keenly aware of the growing customer interest in ESG, and options are multiplying.

While an ESG-themed strategy may align with your worldview and public policy preferences, feeling good about making an investment has the potential to turn off critical thinking. There are numerous instances of underperforming funds re-labeling themselves "ESG." This attempt to increase sales is so common the industry now has a name for it — "greenwashing." Just because the investment manager puts "ESG" or some other kind of green-sounding words into the name of the fund doesn't mean it will accomplish your objectives.

ESG investment strategies should receive the same scrutiny and vigorous due diligence as any other strategy you'd consider, no matter how passionately you feel about a cause. Do your homework to make sure the product you're considering aligns with your beliefs, is managed by a skilled manager, and that you understand the potential opportunity costs. Judging from the growing interest from investors and company board rooms around the globe, ESG strategies are here to stay.

Michael J. Francis is president of Francis Investment Counsel LLC, a registered investment adviser with offices in Minneapolis and Brookfield, Wis. He can be reached at michael.francis@francisinvco.com.