It's important to look at what large pools of capital are doing, especially, in my view, pension plans in part because some of those plans either in defined benefit or defined contribution arrangement represent the investments of many people, including retail investors. The Biden administration recently announced it will change the rules for private-sector pension investing to allow consideration of ESG risks in pension plan investments when the plan managers are considering ESG investments for a plan. In other words, managers could consider potential financial benefits of ESG investments, as well as their social benefits. This could be an important change for private-sector pension plans, which up to now have mostly avoided ESG investments because laws they're subject to especially ERISA and Department of Labor guidance requires that plan investments take only the plan beneficiary interests into account. Under this doctrine, ESG investments are allowed only if they have similar risks and return characteristics to non-ESG investments on a line-item basis. While it may sound like US private-sector pension plans is a narrow regime, that's first of all not true. Pension plans in United States are actually quite sizable but also what happens under ERISA is often echoed in other fiduciary regimes including at the state level and sometimes internationally. Under the new doctrine, if finalized, ESG investments could be considered superior to non-ESG investments if they reduced ESG risks in the plan and analytics support it. The new proposed rules are only the latest development in the long history in the United States of rulemaking for ESG in private pension plans and elsewhere. Perhaps one of the most important mark-to-market on ESG investing as issued in the guidance offered by the Department of Labor came around in 1998 when then director of the Office of Regulation Interpretation Robert Doyle described the following in response to an inquiry. This is often called a no-action letter. Here is what this government regulator said at the time with respect to socially motivated investments, and it's focusing on mutual funds and other funds, but it had broad implications. In discharging investment duties, fiduciaries must, among other things, consider the role of the particular investment in the investment portfolio. Because every investment necessarily causes the portfolio or the plan to forego other investment opportunities, fiduciaries also have to consider expected return on alternative investments with similar risks available to the plan. Now, for any student of investing or any individual investor or even any manager of enterprise or a company, it's important to parse these words because it gives direct and powerful guidance on how then the Department of Labor, the regulator of pension plans, describes how you must handle this analysis. Because every investment has a cost, in other words, it necessarily causes a pension plan or a portfolio to give up another investment opportunity if you are a fiduciary, if you are managing the well-being of someone else financial, you also have to consider the expected return on so-called alternative investments. Here, they don't mean alternatives in the sense of real estate and commodities and hedge funds. They mean investment options with similar risks available to the plan. In other words, holding risk constant, they have to consider expected return. That's the familiar concept of the Sharpe Ratio. If those requirements are met, if the Sharpe Ratio on a line item basis is the same or better, the selection of a socially responsible or today an ETI, an economically targeted investment, mutual fund, or really any fund as either an investment in the portfolio or a designated investment alternative for comparison purposes would not by itself be inconsistent with fiduciary standards. Essentially, it said ESG investing can be quite fine in a pension plan, as long as it doesn't involve a lower risk-adjusted return. Now the evidence that we have presented and others have presented in the academic and practitioner literature, for example, the GSL 2021 study or the investment study, have pointed out that on a side-by-side basis, it's not clear at all that ESG investments have historically resulted, in an average sense, in lower returns. But it does motivate a kind of analytic underpinning that is required. The Department of Labor's policy toward ESG investing for fiduciaries, in other words, most pension plans, as contained in this statement still remains in effect. However, in October 2015, then Labor Secretary Thomas Perez, under the Obama administration, announced what was billed as a very large change. Along with a speech in a news conference, the regulator issued Interpretive Bulletin 2015-01, which is, of course, a page-turner, but it focused on fiduciary standards considering economically targeted investments or ETIs. It was described as a major step in giving fiduciaries wider latitude for social investments. Here ETI is jargon for social investments or ESG or impact investments. Interpretive bulletins are, of course, not actual laws or regulations but give guidance and thinking as to how the regulator will interpret and enforce policy. Because many fiduciaries could be personally responsible for their actions with respect to the wealth of others, this really does have teeth. This document has been removed from the DoL website since 2018 which may or may not be meaningful as it relates to political regimes. The quote by Secretary Perez highlights aspects of ESG investing at the core. Here's what he said, "The question is this: can ERISA plan invest in projects or companies that serve the common good, under the idea that is inherent in ESG of consideration of stakeholder interests and perhaps not only shareholder interests but also tilting into the common good related to the environment, or to certain subsets including suppliers and some of those who work potentially in sweatshops or just generally, in the common good, while still keeping it at the forefront the fiduciary principle than investing prudently and for the exclusive benefit of retirees and workers? I believe we can." What he's saying is the idea that good and gold can't necessarily work together, in fact, may not be true. It may be specifically the case that the common good can be served, at the same time, economics can. He actually went on to say that the 2008 guidance issued years before under the Bush administration actually gave cooties to impact investing. Besides friendlier language, another change is that ERISA fiduciaries underlying investments are now free to consider ESG investments at that point and ESG policies of companies as improving risk and reward. The idea that ESG may have a direct relationship to the economic value of the plan's investment is an advancement above what had been issued previously. It's no longer treating ESG investing as purely a constraint but as a potential non-detractor to risk-adjusted returns and potentially as an avenue to improve risk-adjusted returns.
