ESG: Popular, But Not Simple

Finding appropriate benchmarks for ESG investments in retirement plans will require careful consideration.

After a summer of extreme fires, floods and droughts, environmental, social and governance (ESG) investing prompts great excitement both among investors and the investment industry. Many are motivated by the idea that their savings can be put toward solving some of society’s greatest challenges. 

In spite of significant interest (particularly among younger investors), retirement plan fiduciaries have hesitated to adopt explicitly ESG factors because of a lack of clarity as to whether these factors are appropriate for Employee Retirement Income Security Act (ERISA)-qualified retirement plans. Recently, however, the Department of Labor (DOL) issued a proposed rule that would amend its investment duties regulation related to the use of ESG factors in selecting investments appropriate for ERISA-qualified plans.  The new rule would explicitly give a green light to ESG factors. Given this new regulatory support, undoubtedly a whole new category of ESG funds and strategies will emerge in the universe of investment options.

Notwithstanding this widespread demand and excitement, we want to urge caution to those who are fiduciaries of qualified retirement plans. Any fiduciary that is considering adopting an investment strategy that includes ESG factors should first consult its own fiduciary policies and procedures. Very often, implementing new strategies or adding new fund options requires committee approvals and may require amending other documents, such as an investment policy statement (IPS).

Once procedural requirements are addressed, a fiduciary will need to establish a prudent analytic framework for evaluating ESG managers and strategies. We are far along in our work of creating a process-driven analytic model, and, as we dig into the research, the complexities are multiplying. ESG is a very broad label and managers employ different ESG data sources, factors and techniques in deciding what can qualify as an ESG fund or strategy. Analyzing funds and strategies is not necessarily an apples-to-apples comparison. Best practices, however, suggest that fiduciaries adopt an analytic framework before jumping in and examining specific managers or funds. 

Another issue that jumps out at us as the conversation on ESG investing in retirement plans heats up concerns the benchmarking of ESG portfolios. Benchmarking is an important tool used by fiduciaries to assess the investment performance of an investment manager. How do you analyze an individual manager’s investment performance, or compare the performance of managers against their peers, unless it is compared against a benchmark? 

As mentioned above, within the broad headings of environmental, social and governance, managers employ numerous factors and multiple methodologies in applying these factors. In the context of ESG portfolios, the plan fiduciary’s selection of a benchmark is critically important.

In fact, selecting a benchmark might prove to be more valuable than endorsing any specific ESG factors or data sources. We suggest this hypothesis upon examination of other investment strategies. For example, when fiduciaries review active growth managers, they likely identify the growth factors employed by the manager, and they no doubt validate the investment processes identified by the manager. However, in the end, performance will be evaluated against a benchmark. Performance versus a benchmark remains a key evaluation tool. We predict that the chances are high that, over time, the same dynamic will likely prevail related to ESG strategies.

So, where does the current industry stand with respect to ESG benchmarks? Our initial research reflects that there is an increasing number of ESG benchmarks reflecting various characteristics; some are broad, some are narrow. We welcome this wide array of benchmarks and the analysis and commentary which will naturally evolve. Ultimately, the academic and industry debate on benchmarks will benefit plan participants. At the moment, however, our review and research has not revealed that one benchmark has risen to the level of an industry standard.

When considering whether a published benchmark is appropriate, here are a few questions to ask:

1)    What is the source of the ESG data used to rate the benchmark constituents? What is the criteria for choosing that source?

2)    What ESG factors are used in compiling the benchmark? What is the construction methodology for the benchmark?

  1. What are the rules for including the benchmark constituents?
  2. How are individual companies weighted?

3)    Is the benchmark recognized as a broad and investable index? 

Importantly, selection of a benchmark is not a static event. For those who may remember the early days of international investing, the MSCI EAFE [Europe, Australasia, and the Far East] Index quickly became an industry standard. However, over time, the debate shifted to cap-weighted indexes, equal-weighted indexes and indexes reflecting many different industry tilts. Benchmark selection remains an active topic of review. 

These questions do not yet have answers, but like all the other challenges we’ve seen over the years, they’re coming. We continue to engage with credible sources throughout the industry and urge plan fiduciaries who may be considering adopting ESG strategies to do the same. 

We love the robust dialogue that new options like these ignite. These are exciting times and the excitement in the marketplace is building. Our fiduciary DNA, however, urges prudent decisionmaking.


Mitch Shames, Esq., is the CEO of Harrison Fiduciary Group, a registered investment adviser (RIA).

This feature is to provide general information only, does not constitute legal or tax advice and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of Institutional Shareholder Services Inc. (ISS) or its affiliates.