Unintended consequences are a longstanding effect of public policies, an eternal truth seemingly invisible to one generation after another of policymakers eager to improve upon the economic arrangements emerging from market competition and individual choices. Witness, for example, a regulation implemented by the Securities and Exchange Commission (SEC) in 2003, intended to reduce the scope of supposed conflicts of interest shaping the proxy-vote decisions of mutual funds. It requires management investment companies “to provide disclosure about how they vote proxies relating to portfolio securities they hold.” In the words of the SEC, “funds have been reluctant to disclose how they exercise their proxy voting power” with respect to the securities that they hold in their portfolios.

Because of staff interpretations of that regulation, it evolved from a simple requirement for management transparency into an SEC policy that all mutual funds vote on all proxy issues, with the added feature of an almost blanket exemption from liability for advisers providing fund managers with recommendations on how to vote.

The combination of the requirement and the exemption led unsurprisingly to an outsourcing of the funds’ policies on such proxy voting. After all, neither disclosure nor its adequacy is ever very simple, and disclosure inexorably leads to complaints about the ensuing proxy decisions. Were the decisions consistent with the disclosures in any given case? The plaintiff attorneys would love to ask that question. Accordingly, there is no better way to keep the lawyers and their favorite tool — litigation — at bay than transferring such proxy decisions to outside “experts.” Alas, those outsiders, like most individuals and institutions, have their own set of interests and biases, and there is no particular reason to believe that the experts’ preferences are consistent with those of the investors in a mutual fund.

That is an obvious reality a fortiori for public pension funds; their market returns do not affect directly the financial fortunes of their decision makers, unlike the case for those managing private mutual funds. The managers of the private mutual funds, as a crude generalization, do well when their investors do well. Whether for public or private funds, however, poor investment decisions by fund managers will harm the investors directly, an outcome not to be facilitated by public policies.

ESG Investing

This brings us to the growing influence of “environmental, social, and governance” (ESG) investing, now all the rage. In plain English, ESG investment choices substitute an amorphous range of political goals in place of maximizing the funds’ economic value — that is, the wealth and pension benefits of current investors. Precisely because political goals are, well, political — they are shaped by conflicting value judgments, policy interests, and other such objectives about which there is strong disagreement — there is no obviously “correct” set of investments that satisfy the political demands of the myriad “stakeholders” interested in how the funds allocate their capital. That is: Any number of alternative politicized investment choices can be advocated as vehicles to use the fund investments to serve the “stakeholders’” interests rather than those of the investors.

And so back to the experts. They can help avoid lawsuits and they can help sort through the conflicting objectives that ESG investment choices inevitably offer. One obvious reality is that this “sorting” service is utterly arbitrary, precisely because the options are political, leaving enormous scope for conflicts of interest, about which more below. Another reality about such advisory “services,” one far more subtle and thus little noticed: The bigger the proxy advisor — that is, the larger its market share in such advisory services — the more difficult it is for anyone to accuse the fund managers of cherry-picking among alternative advisors. In other words, the proxy-advisory “market,” created by a regulatory intervention, is characterized by enormous economies of scale, which, having nothing to do with cost conditions, are wholly artificial. And so it is unsurprising that two such proxy advisory firms have acquired virtually the entire market: Institutional Shareholder Services (ISS) and Glass Lewis (GL).

As noted above, those managing private mutual funds have incentives to maximize returns, as their interests are consistent with those of the investors. For the managers of public pensions funds: not so much, because the returns to those funds do not affect directly the financial fortunes of their decision makers. A fortiori, neither ISS nor GL has any direct stake in the economic performance of the funds to which they proffer advice; instead, they receive fees, whether by the hour or as a lump-sum contractual figure.

More important, they operate by virtue of SEC regulations and oversight of the mutual funds, and in the crucial case of the public pension funds, there always is the possibility (or threat) of unhappiness on the part of various public officials. In a word, their activities are politicized to some nontrivial degree simply as an unavoidable outcome of the system within which they operate. Moreover, ISS and GL, owned and operated by mere mortals responding to the incentives with which they are confronted, and harboring biases and preferences of the sort characterizing all of us, are happier to indulge their political preferences when doing so comes at costs borne by unknown third parties. Why not, then, engage in some old-fashioned virtue signaling in the form of proxy advisory services biased in favor of politically correct objectives?

Conflicts of Interest

And since the fund managers have strong incentives to adhere to the advisors’ recommendations, why not get in on both sides of the game? Thus, for example, does ISS sell consulting services to corporations, advising them on how to get favorable proxy recommendations from that very same ISS. GL apparently does not offer this consultant service directly, but has a strategic partnership with Sustainalytics, in which GL “will integrate Sustainalytics’ ESG research and ratings on more than 10,000 companies into Glass Lewis’ proxy research and vote management platform.” Both of these arrangements are blatant conflicts of interest, and it is rather amazing that the SEC has not addressed them, although now after 15 years it is beginning to ask the relevant questions:

[One area] that may warrant particular attention:

Whether there are conflicts of interest, including with respect to related consulting services provided by proxy advisory firms, and, if so, whether those conflicts are adequately disclosed and mitigated.

This kind of game playing is facilitated by the highly subjective nature of ESG investment choices: Precisely which political goals are appropriate and how does one reconcile the conflicts among them? Should funds invest in firms with inner-city plants, thus providing greater employment opportunity for nearby residents? Or should the tenets of “environmental justice” be given greater weight, perhaps reducing localized emission levels at the cost of the aforementioned expansion of job openings? How many business enterprises are in a position to evaluate the cost versus environmental tradeoffs inherent in “renewable” energy investments (note that such tradeoffs almost certainly are unavailable). In the wise words of SEC Commissioner Hester M. Peirce: “Does a company that brews beer really have the expertise to assess what energy source would be the best for the environment?” And what weight should be given the political preferences of the funds’ investors? Some may applaud disinvestment from, say, fossil fuels, while others may not. How can such conflicts be reconciled in the context of public pension funds from which the investors cannot exit? Answer: They cannot.

Erosion of Fiduciary Responsibility

Let us turn now to the other major conflict inherent in ESG investing: the erosion of funds’ fiduciary responsibility to their investors. Advocates of ESG investing often assert that such “socially responsible” investment choices do not have to come at the expense of lower returns. That argument is deeply dubious; after all, the imposition of an artificial investment constraint — no, say, to oil companies — cannot yield a systematic return higher than a set of options without such constraints. That truism is clear in the evidence; consider, for example, the effects of divestment from fossil-fuel producers. University of Chicago Law School emeritus professor Daniel R. Fischel found in a study that:

[Of the] 10 major industry sectors in the U.S. equity markets, energy has the lowest correlation with all others, followed by utilities — meaning that companies in these sectors provide the largest potential diversification benefit to investors, and that divestment would reduce returns substantially. In particular, Professor Fischel’s study tracks the performance of two hypothetical investment portfolios over a 50-year period: one that included energy-related stocks, and another that did not. The portfolio which included energy stocks generated average annual returns 0.7 percentage points greater than the portfolio that excluded them on an absolute basis and 0.5 percentage points per year higher on a risk adjusted basis. In other words, the “divested” portfolio lost roughly 50-70 basis points each and every year over the prior 50-years. Professor Fischel’s study also found that ongoing management fees are likely to be as much as three times higher for a portfolio divested of fossil fuel stocks.

The Department of Labor (DOL) earlier this year made clear the fiduciary responsibility of fund managers to their investors for private funds governed by the Employee Retirement Income Security Act of 1974 (ERISA):

Fiduciaries must not too readily treat ESG factors as economically relevant to the particular investment choices at issue when making a decision. It does not ineluctably follow from the fact that an investment promotes ESG factors, or that it arguably promotes positive general market trends or industry growth, that the investment is a prudent choice for retirement or other investors. Rather, ERISA fiduciaries must always put first the economic interests of the plan in providing retirement benefits. A 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.

In short, ESG investment constraints are not particularly important for private defined-benefit retirement plans because those plans are subject to the fiduciary requirements — “loyalty” and “prudence” — that ERISA imposes upon the fund managers. Wayne Winegarden notes, “In 1980, a key DOL official published an influential article warning that the exclusion of investment options would be very hard to defend under ERISA’s prudence and loyalty tests.”

Public pension funds are subject to state laws and regulations instead of ERISA requirements. Public employees cannot exit their pension plans — California public employees must participate in the California Public Employees Retirement System (CalPERS) — whether they approve of ESG policies or not. SEC Commissioner Hester M. Peirce again:

The problems arise when those making the investment decisions are doing so on behalf of others who do not share their ESG objectives.  This problem is most acute when the individual cannot easily exit the relationship.  For example, pension beneficiaries often must remain invested with the pension to receive their benefits.  When a pension fund manager is making the decision to pursue her moral goals at the risk of financial return, the manager is putting other people’s retirements at risk.

ESG Investing Penalties      

And so it is not surprising that ESG investing by public pension funds has yielded penalties for investment returns. (In many cases it is taxpayers who would have to finance the unfunded pension liabilities of the funds.) A study from the Manhattan Institute found “a negative relationship between share value and public pension funds’ social-issue shareholder-proposal activism — which is much more likely to be supported by proxy advisory firms than by the median shareholder.” More specifically, for the five-year period ending June 30, the annual average return for CalPERS was 5.6 percent, while the Vanguard Balanced Index Fund earned 7.8 percent. Dan Bienvenue, the CalPERS managing investment director for global equity, acknowledged recently that its ESG-related investments have underperformed:

Bienvenue said CalPERS started to use the [ESG-related] HSBC index in 2010 but it had underperformed its benchmark over the long term. The index had a lot of exposure to companies working on the clean energy transformation, many of them based in Europe and dependent on government subsidies to make improvements on their sustainability policies, he said. “A lot of those subsidies dried up and so the performance wasn’t horrible, but it definitely underperformed, I think, in certainly most, if not all, time periods,” Bienvenue relayed.

The newly elected member of the Calpers board, Jason Perez, defeated Priya Mathur, a member of the board for 15 years; she also was the board president and an advocate of ESG investing. In a candidate statement Perez made the following observation:

All legal investments must be considered. Sometimes we make an investment decision to invest in socially unacceptable companies such as firearms and tobacco. We invest in these companies for the expected returns, [not] as a moral judgment. Divesting from the tobacco industry has cost our retirement fund dearly, $8 billion lost. Recently there was a motion made by a board member to divest from any company manufacturing or selling firearms or accessories. The motion included any firearm accessory, ammunition, magazines, etc. If the motion had been successful, CalPERS would have divested from not only the manufacturers, but also large retail stores such as Walmart, Big 5 Sporting Goods, Cabela’s, and Outdoorsman. Thankfully, the Board did not even have a member second the motion due, in large part, to the testimony of more reasonable people. This example clearly shows how CalPERS is being used as a Political Action Committee as opposed to a retirement fund.

Fiduciary Responsibility

And that statement says it all: We should not play political games with other people’s money. That gamesmanship is the very essence of ESG investing, with all of the self-dealing and other perversities that politicized investment choices offer. It is time for the SEC to reconsider the 2003 regulation on proxy disclosures — investors can make their own judgments about whether mutual funds are serving their interests, and absent that reform, some serious constraints on the obvious conflicts of interest characterizing the behavior of the proxy advisor firms (ISS and GL) must be imposed. Given that taxpayers must make up the unfunded liabilities of the public pension funds, it is unacceptable that their managers be allowed to shunt aside the normal fiduciary responsibility to maximize risk-adjusted returns.