401(k) ESG Investing: How Responsible Are Your Funds?
If you think you’re hearing more about ESG and sustainable investing, you’re right. Assets are growing in mutual funds and ETFs that seek out companies exhibiting the values shared by their investors. According to the Forum for Sustainable and Responsible Investment, assets categorized as sustainable, responsible and impact investments accounted for 21% of professionally managed assets in 2016. If you don’t know what ESG investments are, ESG stands for Environmental, Social and Governance – and ESG funds follow a set of standards for a company’s operations and only invest if in a company’s stock if it meets those standards.
So should you consider including ESG funds in your 401(k) or 403(b)?
Like value or growth styles, responsible investing means different things to different investors. Socially responsible investing (or SRI) has been around at least since the 1970s. This approach “screened out” companies that clashed with the values of the investor. Tobacco, liquor and gambling stocks often fell into this category.
Today the term “ESG investing” has become a common way to describe investments with certain socially conscious attributes. Rather than to screen out companies, ESG investors are looking for companies with favorable environmental, social and governance factors. A qualifying company may efficiently use water in their manufacturing process, invest in environmentally friendly technology, or actively seek locations for new businesses in underserved communities. An often overlooked aspect of ESG attributes is sound corporate governance – practices like ethical behavior and sound financial reporting.
Different funds may have different mandates when it comes to seeking out sustainable or ESG companies. Some may exclude entire industries while others may look for the best practices within each industry. Some funds label themselves as ESG funds. Others don’t adopt the label but do seek out companies with Environmental, Social and Governance attributes.
Quantifying ESG fund managers for your 401(k) or 403(b)
There are even third parties that rate companies based on sustainability or ESG practices. Fund data provider Morningstar now includes a sustainability rating among its fund metrics. The rating, which Morningstar says “provides a reliable, objective way to evaluate how investments are meeting environmental, social and governance challenges,” is available for 20,000 funds worldwide. Only a small percentage of these funds actually label themselves as socially responsible. The ratings reflect the business practices of the underlying companies.
How do ESG funds perform?
Advocates of ESG investing argue that the approach does not require a tradeoff between socially responsible behaviors and investment performance. Rather, they argue that ESG companies are often better than average investments given their commitment to sound governance and an appreciation for the long-term implications of their actions.
Morningstar’s head of sustainability research says there is little evidence there is a penalty to sustainable investing by mutual funds. In fact, there may even be a performance advantage. A 2014 study by Oxford researchers concluded that the body of research on ESG investing reveals that sustainable companies are more likely to have a lower cost of capital, better operational performance and even better stock price performance. It is important to note that at ForUsAll, we do not suggest that ESG funds have superior performance vs. other low-cost 401(k) investments, but do will evaluate ESG funds – especially if the company or nonprofit we are advising so requests.
ESG investing and your firm’s retirement plan
Despite the growing awareness of Environmental, Social and Governance investing, explicitly labeled ESG funds are rarely found in 401(k)s and 403(b)s. That’s largely due to the cold shoulder the Department of Labor has given these funds over the years. In 2008 the DOL indicated that plan sponsors should only rarely consider fund attributes other than risk and return. That sentiment scared off plenty of plan sponsors interested in adding an ESG fund to the lineup.
But it seems the DOL has softened its approach, and ESG funds may soon become more common in 401(k) and 403(b) accounts. The DOL issued new guidance in October 2015 saying that funds shouldn’t be considered suspect just because they take into consideration ESG factors.
But so far adoption has not been widespread. In 2016, just 8% of Vanguard defined contribution plans offered funds to participants labeled “socially responsible.”
