SEC Proposals for ESG Ignore 80 Years of Financial Science – ValueWalk Premium
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SEC Proposals for ESG Ignore 80 Years of Financial Science

The US Securities and Exchange Commission is concerned that retail investors who want their investment managers to factor environmental, social and governance considerations into investment decisions are being duped by “greenwashing” — token actions with no material effects —and marketing materials that overstate what the managers are actually doing. This is a valid concern, but the SEC’s solutions are straight out of the New Deal, top-down playbook from the 1930s.

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The first change proposed by the SEC is to apply the “80% rule” to funds with names that suggest a focus on ESG focus, meaning 80% of the asset value of the fund must be in assets described by the name. But for the last 70 years, Modern Portfolio Theory has held sway in finance. You don’t evaluate investment securities one at a time; you look at the statistical properties of the portfolio as a whole.

This idea is clearer with international stocks funds than with ESG. In the late 1980s, foreign stocks were strongly outperforming US stocks, so foreign stock and international stock mutual funds became popular. The easiest way to make a stock fund international was to buy large-cap, multinational companies that happened to be headquartered in Europe, Japan or elsewhere. But these companies were influenced by the same economic fundamentals as large capitalization US multinational companies, so the resulting funds had high correlations to the S&P 500 Index, often higher than most US equity funds.

What investors wanted wasn’t a high proportion of fund assets in companies domiciled outside the US, they wanted low correlation to the S&P 500 for diversification, and high correlation to foreign stock markets because those were doing well. That was harder to deliver because it meant going into foreign stock markets, analyzing companies that used unfamiliar accounting principles and whose documents were not always available in English, working with foreign banks and dealers, understanding differences in legal jurisdictions, etc. When you did that, you found that there were US-domiciled companies with strong foreign stock exposure, and foreign-domiciled companies with little foreign stock exposure. The optimal portfolio balancing S&P 500 correlation, foreign stock correlation and expected return might have more than 20% US-domiciled stocks.

The SEC proposal assumes a “Santa Claus” strategy. You make a list of naughty and nice stocks, and make sure 80% of your picks are from the nice list. But this is a silly way to advance ESG goals (and I don’t think it’s much good for getting children to behave either). I’ve spent a lot of time talking to investors concerned about ESG and what most of them want is an overall portfolio that will both make the world a better place and deliver a profit as the world becomes a better place. They want exposure to an “ESG factor,” not 80% of their money in nice-certified companies.

The 80% rule does not actually mandate a Santa Claus strategy. A manager could use a dynamic portfolio strategy and argue that 80% of the assets were directed toward the strategy goal. But that’s expensive and risky, and most managers won’t do it. The SEC blocks innovation not just by outlawing things. There was no law against innovations like money market funds and index funds, but people who tried to offer these things were frustrated for years by ticky-tack SEC objections and foot-dragging. Moreover, they needed determination and courage because many of them went broke trying or were hit with regulatory sanctions.

The other SEC proposals focus on disclosure. One major issue — which I expect will be corrected during the comment period — is that the “Scope 3” obligations go far beyond public companies to everyone the companies do business with. Nestle can fill out long forms about its carbon emissions at a cost that is a negligible fraction of its revenue. But a farmer selling crops to Nestle could find filing those disclosures prohibitively costly. The more basic problem is disclosure assumes a top-down perspective. Investors decide what is good and bad for ESG and instruct their managers, the managers tell the business executives what to do, who tell their employees and suppliers. The purpose of disclosure is for investors to make sure the employees and suppliers at the end of the line are following orders.

Read the full article here by , Advisor Perspectives.


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