Navigating the DOL’s new ESG guidance

We believe a deep understanding of how ESG factors impact security prices can help investors navigate the complex landscape of responsible investing.

If the Obama Administration’s 2015 and 2016 guidance related to investments that are influenced by environmental, social and governance (ESG) factors was intended to open the ESG floodgates for 401(k) and pension assets…. then the current Administration’s guidance, released this week by the U.S. Department of Labor (DOL), ostensibly is intended to stem the growing ESG tide.

There are several reasons why the Administration and the DOL may have decided to issue this guidance now.  In any event, as an article in Bloomberg stated, the “guidance aimed at the burgeoning socially-responsible investment industry…left some investors scratching their heads.”

When determining what investments are appropriate for a plan and its beneficiaries, the DOL reiterated in the guidance its long-held view that an ERISA fiduciary’s “evaluation of the economics of an investment should be focused on financial factors that have a material effect on the return and risk of an investment based on appropriate investment horizons consistent with the plan’s articulated funding and investment objectives."

Let’s restate a key point: an investor’s evaluation should be focused on financial factors that have a material effect on the return and risk of the investment.

Over the past few years, we have seen growing interest in ESG from plan sponsors, plan beneficiaries, advisors, and retail investors. The DOL’s new guidance is intended to convey caution to ESG-minded fiduciaries and their advisors.  And yet, while the intended effect of this may be to dampen the growing use of and enthusiasm for ESG, we agree with the substance of the message: that materiality does indeed matter.

We believe that a focus on materiality should guide all ESG decisions as part of a robust process of evaluating all facets of a plan’s design or an investor’s strategy, as well as the benefits to that investor or plan beneficiary. A fiduciary who is thoughtful and thorough in its process should be considering ESG factors in all of its decision-making, just as it would consider other risks and rewards.  Understanding what is material—and why—is foundational to that process and outcome and can help investors accelerate and deepen their application of ESG factors.

Best practices for ESG investing

My colleague, Leola Ross, director, investment strategy research, notes two key beliefs we hold on ESG factors:

  1. Our quantitative research indicates that ESG factors impact security prices. Note that she said they impact security prices…Leola didn’t say which direction.  In fact, ESG factors can impact security prices both upwards and downwards. Understanding the circumstances under which ESG impacts prices is the key (how, when, and how much?).
  2. A deep understanding of how ESG factors impact security prices is value-adding to a skillful investment process. Russell Investments embeds ESG into a variety of aspects of our investment solutions, including our asset-class research and our multi-manager research. This research is what guides our strategic and tactical asset allocation in portfolio design, portfolio construction, and our management of portfolios.

So, when it comes to ESG, the combination of these two beliefs is the cornerstone of our investment practices—practices that are designed to stand up to the strictest fiduciary scrutiny.

Matters of materiality

Russell Investments has helped propel the ESG conversation forward in recent months in ways that can help fiduciaries better understand how they can incorporate ESG criteria into their investment practices.

We recently developed the Material ESG Score. This materiality scoring draws from metrics developed by industry leaders Sustainalytics and SASB (Sustainability Accounting Standards Board). Our material ESG scores are designed to identify and evaluate only those issues that are financially important to a company. The new material score allows us to differentiate between companies in a way that the traditional aggregated ESG score does not facilitate. We can now distinguish between companies who score highly on issues that are not financially material to their business.  If you read the DOL’s recent guidance, this should sound familiar and extremely helpful as you think through how to shape your plan design and investments relating to ESG factors.

One aspect of this scoring is that our research suggests that the Russell Investments’ material ESG scores are more relevant to investment returns compared to traditional ESG scores.

To explain this further, we lay out hypothetical examples of two companies investing in the ESG-related improvement of fuel efficiency. One is a bank and one is an airline. For a bank, an investment in fuel efficiency is relatively immaterial to their business, so that investment will likely be a drag on their stock performance. On the other hand, if an airline makes major improvements in fuel efficiency, they could very well see a related improvement in their stock price because fuel efficiency is material to an airline.

A recommendation for support

Expertise in this area and ongoing research into the materiality scores of individual securities requires deep resources and deep experience. We highly recommend that investors do not go this alone. The new DOL guidance is correct that, without proper research and resources, it is very possible for investors to swap performance and risk control for ESG exposure. But with the right support, we believe investors can have the performance they need and their ESG factors too.