The ESG saga of 2020 continues. In late October, President Trump's Department of Labor passed a hotly contested rule that essentially prevents 401(k)s from offering ESG investments to plan participants.
More recently, Rep. Andy Levin (D-Mich.) announced that he's drafting two bills that take the opposite stance. Levin's legislation, if passed, would require 401(k) plan administrators to adopt and publish an ESG investment policy, which means ESG funds could soon be an option in your retirement plan after all.
Levin's bills, called the Sustainable Investment Policies Act and the Retirees Sustainable Investment Policies Act, aren't slam dunks, even with a Democratic president-elect waiting in the wings. Levin doesn't currently have the bipartisan support needed to pass his legislation this year. He has said he will put the bills before Congress again next year if necessary. His odds of success probably hinge on which party ends up in control of the Senate after the two runoff elections in Georgia.
ESG is a label that designates organizations with sustainable business practices in three core areas: environment, social, and governance. The environmental component involves the company's energy efficiency, pollution impact, and carbon footprint. Social issues include the company's policies around human rights, gender diversity, and data privacy. And the governance part covers accounting transparency, codes of conduct, composition of the leadership team, and executive compensation.
ESG stocks are investable companies with good track records in all three areas relative to their peers. These are mutual funds and exchange-traded funds (ETFs) that build their portfolios with ESG stocks.
Sustainability alongside financial performance
ESG investors and fund managers believe sustainable business practices and financial performance go hand in hand, in the near term and long term.
The long-term benefits of sustainability are easy to grasp, particularly with energy consumption. Consider the estimate from Stanford University's Millennium Alliance for Humanity and the Biosphere that global oil resources will run out by 2052. A company that's reducing its oil dependence today should have the advantage as those resources start to run dry.
But ESG companies are also showing strength in the near term. The chart below shows the growth of $10,000 invested in the S&P 500 index versus the S&P 500 ESG index, which includes only companies that meet sustainability criteria. You can see that the ESG portfolio has slightly outperformed the non-ESG index over the last five years. Several studies have also concluded that ESG stocks perform as well as their traditional counterparts and can even be less volatile in market downturns.
Given that ESG stocks and funds have demonstrated financial strength, you might wonder what's driving the ESG controversy on Capitol Hill. It's a battle of perspectives. The Republican Labor Department's argument is that retirement accounts should focus on the financial betterment of U.S. workers, not on other agendas, including sustainability. Proponents of ESG funds argue that these investments do perform financially, with the added benefit of promoting the well-being of the planet and its people.
Some ESG funds "feel" better than others
Saving the earth while strengthening your finances might sound pretty compelling. But investing in ESG funds has its pitfalls. For one, there are no agreed-upon standards for ESG screening criteria. Instead, ESG fund managers get to set their own rules. Some will exclude all companies within controversial industries, such as tobacco or firearms. Others might include a tobacco company, for example, because it has the best ESG record among its peers.
Some funds have stretched the boundaries of ESG far enough to be accused of "greenwashing." This is the practice of using the ESG moniker while selectively overlooking common ESG screening practices. An example would be a clean-energy fund that has oil and gas exploration stock hiding in its portfolio.
The takeaway? If you're drawn to an ESG fund for the feel-good factor, pay close attention to what's in the portfolio. You'll find that some funds feel much better than others.
Watch those fees
A second pitfall is the potential for higher fund fees. Passively managed index funds often have expense ratios below 0.10%. With ESG funds, it's more common to see expense ratios above 0.10%, ranging up to 1% for actively managed funds.
The difference between expenses of 0.10% versus 0.50% on similar funds can be significant over time. Say you invested $5,000 annually for 30 years in two funds, and both grow at 7% on average before fees. In that time, the fund charging 0.10% will cost you about $8,400 in total. But the more expensive fund will cost more than $40,000 -- nearly $32,000 more.
Where you can invest in ESG right now
Levin's ESG legislation is an interesting political move, but it's likely to face opposition unless the Democrats gain control of the Senate in January. In the meantime, if you want to pursue sustainable investing, start by becoming a student of low-cost ESG funds. Learn how they screen, what benchmarks they use, and how their performance compares to non-ESG counterparts. When you're ready, you can start to invest in an IRA or a taxable brokerage account.
If ESG funds do eventually make it to your 401(k), you'll have the expertise to evaluate them and decide if they have a role in your retirement savings plan.