Not investing in ESG doesn’t make you anti-ESG

As the environmental, social and governance space evolves, we're learning that the value from an investment perspective is not always best, even if it's always good.

ESG investing is going through a rough patch, which is going to put some folks on the defensive and leave others saying, “I told you so.”

There just doesn’t seem to be any middle ground these days when it comes to the topic of investing around environmental, social and governance causes.

To call ESG investing a political football would be an understatement. It currently represents the most contentious investment category of our times. The blame for that is widespread and includes the media and politicians, as well as some of the more ferocious ESG supporters, who can make innocent bystanders feel like they’re trapped on an elevator with one of those kiosk guys at the mall hawking skin cream.

Financial advisors, in general, could be politely described as lukewarm on ESG, which ESG proponents often attribute to the financial advisory space being made up mostly of old white men who only care about profits and hate the planet and its inhabitants.

I’m exaggerating, of course, but not by a lot. Fact is, this has become such a divisive issue that even prioritizing risk-adjusted investment performance over ESG causes is now being defined by some as anti-ESG.

My sense is that advisors who shy away from ESG are focused on the higher fees and inconsistent performance, but I also know a lot of advisors who are very much on board the ESG train.

Let’s look specifically at that rough patch I referenced earlier.

According to Morningstar, at the end of last year the ESG funds in its database combined for a total of $286 billion in assets. That total, which included $3 billion worth of net inflows, was down more than 20% from the end of 2021 because of investment performance.

Aided by $69 billion in net flows, ESG fund assets peaked at $360 billion at the end of 2021, which represented a high-water mark; that was preceded by peaks of $236 billion in 2020 and $137 billion in 2019.

While some might view the sudden asset drop-off last year as a major setback for ESG, a more prudent perspective would be that this is just another stage in the evolution of the category. And that evolution is being molded to some extent by crafty politicians in search of populist bandwagons to board.

That’s essentially how we ended up with three years of rolling ambiguity from the Department of Labor about whether defined-contribution retirement plans can or should include ESG funds as menu options for plan participants.

The back-and-forth, which started in earnest during the Trump administration and ultimately led to a veto by President Joe Biden earlier this year, boils down to where ESG criteria can be considered by plan sponsors when selecting investment options for employees saving for retirement.

As the rule currently stands and will remain until at least the end of Biden’s presidency, plan sponsors are allowed to consider ESG factors when adding funds to the investment lineup.

If your reaction to that much celebrated and expensive political victory is whoop-de-do, you’re not alone.

Without overthinking whose bread might be getting buttered by all this politicking over how and why ESG funds are made available to retirement savers, let’s not ignore the awesome potential of the multitrillion-dollar DC plan market.

Getting a foot in the door is what it’s all about. It’s no accident that firms like Fidelity are ramping up target-date funds with an ESG flavor for a long-shot bet on getting a piece of the default allocation for any savers who aren’t paying enough attention to choose their own investments.

The ESG lobby has been trying to crack into the bountiful DC plan market forever, and Biden’s big veto might help that cause. But nobody should expect any sudden moves.

Remember, the final gatekeepers for DC plan menus are fiduciaries born and bred to err on the side of extreme caution. So while being a political football might draw welcome attention to the ESG space, it also triggers the antennae of those plan fiduciaries desperately trying to protect plan participants from any unnecessary risks.

As Morningstar senior analyst Lia Mitchel points out, it’s no accident just 16% of DC plans offer access to an ESG strategy.

[More: The Bud Light case for ESG]

More telling, however, is the fact that, according to Morningstar’s most recent data, ESG funds in DC plans represent just $50 billion, or about half of one percent, of the more than $8 trillion invested in DC plans.

“There’s plenty of plans starting to offer ESG funds, but there’s still not a ton of assets,” said Mitchel, who believes the key is somehow getting ESG strategies locked in as default options.

For a perspective on that challenge, look no further than the iShares ESG Aware MSCI USA ETF (ESGU).

With $14 billion in assets, ESGU is the largest ETF in the ESG space, but it has endured a black eye this year in the form of more than $6 billion worth of outflows. While this might look like another hefty blow to the midsection for the ESG cause, it more likely boils down to that pesky reality of valuations over values.

According to Todd Rosenbluth, head of research at VettaFi, the flows out of ESGU this year can be directly tracked to a popular BlackRock model portfolio that recently replaced ESGU with the iShares MSCI USA Quality Factor ETF (QUAL).

Looking past the ESG moniker, ESGU is a strategy with a quality tilt, and quality is hot this year. But the QUAL factor strategy is focused specifically on quality, which is why its 8.9% return this year is beating ESGU by 2.6 percentage points.

So even BlackRock, the world’s largest asset manager and a leading proponent of ESG investing, is placing performance potential ahead of whatever benefits ESG investing might produce.

None of this is a knock on ESG investing or its potential benefits well beyond financial services. It just shows how, sometimes, not wanting to invest in ESG strategies doesn’t automatically make anyone anti-ESG.