Traps Awaiting Unsuspecting RI Investors
Last week, we noted the tendency of the financial industry to take advantage of investors, including responsible investing (RI) investors. We also observed how this led to the epidemic of greenwashing: recharacterizing rather ordinary investments as RI investments. This week we’ll move beyond the greenwashing problem and look at other pitfalls for RI investors.
Think about risk as well as returns
If a particular RI investment has tended to show good returns, that only answers the first question. The second, decisive, question is: How risky is it?
If the returns are good but the volatility is very high, the risk-adjusted returns are going to be poor. If there is no obvious exit from an impact investment, the risk is unacceptably high. And remember that some RI investments can also significantly reduce portfolio diversification.
Be sure the RI fund you’re buying agrees with your worldview
It can be comforting simply to buy a fund labeled as “socially conscious,” but the fund’s view of what that means might be very different from your own view.
If you are a died-in-the-wool environmentalist, for example you probably should avoid a certain socially responsible ETF where the largest single holding is the oil and gas company, Total. The same goes for a socially responsible investing UCITS ETF, which holds four oil companies.
Finally, be sure you understand the criteria for inclusion in or exclusion from the fund. The Wall Street Journal reported last fall that Tesla was rated the top RI carmaker by MSCI’s ESG index, but was rated the worst RI carmaker by FTSE’s ESG index.
Don’t ignore fixed income
Most RI investments focus on equities, including private equities, where the emphasis is on impact investments. But don’t overlook fixed income.
In both the municipal and corporate bond sectors, many opportunities exist to invest in bonds issued by entities whose overall strategies meet RI principles. In addition, investors can buy bonds issued to support specific projects focused on affordable housing, clean water and energy, economic mobility, mass transit, and so on.
Most RI bond managers adhere to the Green Bond Principles and/or Sustainability Bond Principles, and some of the better managers take an activist approach, engaging in active dialogue with issuers. But be sure you are well-diversified (some managed portfolios own as few as ten issues) and that you are paying attention to duration (RI bonds tend to have longer maturities).
Does the RI fund you like actually walk-the-walk?
Some gender diversity funds don’t just talk-the-talk, they actually walk-the-walk, voting reliably for every shareholder resolution calling on companies to increase the number of women on boards and in senior management. But one gender diversity fund supported only 20% of such proposals.
In addition, the WOMN ETF has a 76 basis point fee, versus 9 basis points for the SPY index – hardly an RI-friendly attribute. An alternative, the SHE ETF has a more investor-friendly fee – 20 basis points – but hasn’t performed terribly well.
Similarly, Morningstar found that many funds working on controlling greenhouse emissions voted against shareholder proposals addressing climate change.
Obviously, serious diligence is warranted before investing in such funds.
What happens after you invest?
If we invest in RI funds, how do we know how well we’re doing, and how do we know whether our RI investing is actually making a difference, as opposed to just making us feel better?
Unfortunately, the technology required to answer these questions has lagged far behind the enthusiasm for putting money into RI. There are, to be sure, ESG indices that we can compare our results to, but unless the compilers of the ESG index happen to agree with us precisely about the ESG issues that are important, comparing our results to those indices will be mostly a waste of time. Worse, looking only at an ESG index doesn’t tell us what cost we’re paying versus a straight index like the S&P 500.
In some specific ESG sectors – impact investing, for example – new performance analytics are developing rapidly. The Rise Fund, a $2 billion impact fund launched by TPG, recently spun off Y Analytics, a new firm that is designed to help investors evaluate the economic value and risk associated with impact investments.
For now, the outcomes measured by Y Analytics are largely output measures – how many people were reached by a responsible-drinking project for college students, for example. That’s a useful metric, but whether the program actually affected student behavior is a much more complex topic.
In addition to Y Analytics, Cambridge Associates and the Global Impact Investing Forum have collaborated to launch the Impact Investing Benchmark. At the moment the database of impact funds is small and new, but the benchmark should improve with age.
Still, the reality remains that, while we can tell how we’re doing against some ESG index or other, and against non-ESG indices, it’s extremely difficult to know whether we’re actually making a difference in the world. For now, and probably for a long time to come, we’ll have to take it on faith that RI truly makes a difference.
Use special caution if you are a fiduciary
Although fiduciary law seems to be slowly evolving in favor of RI, you don’t want to be the one who takes the lawsuit. The US Department of Labor has weighed in on the appropriate use of RI in the ERISA context many times: in 2008, 2015, 2016, and again last year. The SEC and the Certified Financial Planner Board have also issued, or threatened to issue, fiduciary standards focused on RI.
The core problem is the “duty of loyalty,” i.e., whether, when investing on behalf of someone else as a fiduciary, you can consider anything other than maximizing risk-adjusted returns. The mere fact that you, as the trustee, happen to believe fervently in RI isn’t going to sit well with the court if the trust performs poorly and the beneficiaries sue you. Consider the comment to Section 5 of the Uniform Prudent Investor Act:
“No form of so-called ‘social investing’ is consistent with the duty of loyalty if the investment activity entails sacrificing the interests of trust beneficiaries … in favor of the interests of the persons supposedly benefited by pursuing the particular social cause.”
And this is especially the case if the RI issues you believed in happen not to have been material. As an SEC Commissioner recently put it, “When a pension fund manager is making the decision to pursue her moral goals at the risk of financial returns, the manager is putting other people’s retirements at risk.”
Next week we’ll inquire into some of the more philosophical issues that bedevil successful RI investing.
Next up: Responsible Investing Without the Hype, Part III