It’s increasingly dangerous terrain for pension professionals and muni bond underwriters, although there is now a glimmer of hope on the horizon that a defensible screening process is achievable. And maybe artificial intelligence models can someday help replace doctrinaire belief systems with expert statistical forecasts. But first, some historical context.
Ever since the 1970s’ political movements for pension and endowment funds to divest from companies doing business in apartheid South Africa, the concept of social investing has been contentious. In addition to ideological disputes, there was uncomfortable end-game evidence that many public pension funds undertaking “Free South Africa” divesting shot themselves in the foot: When the regime changed, those divestiture stock prices recovered faster than the pension funds were able to reverse their policies, resulting in underperformance relative to their benchmark indexes.
Ever since, opponents of social investing and its ESG descendant have maintained that investment markets function with far more speed and efficiency than pension fund trustees can, operating as they must in a goldfish bowl with sluggish, protracted policy deliberations. It’s thus a breach of fiduciary responsibility, the ESG foes’ argument goes, to underwrite what are almost certain to be ill-timed and unproductive investment strategies.
So when ESG investing concepts began to gather steam in the university endowment world, it took some time for public pension funds to follow suit. Whereas an endowment fund separates the interests of benefactors from the investment outcomes, a pension fund really cannot shortchange its investment returns for the sake of principles alone. Taxpayers are unquestionably on the hook for underperformance.
But with their earlier efforts to rein in miscreant corporate leaders through shareholder activism fresh in mind, it was a natural and logical policy jump for watchdog state pension trustees to subscribe to the “G” (for corporate governance) aspect of ESG investing. Then, as it became increasingly clear that global warming was a major contributor to climate change, the “E” dimension of ESG became increasingly defensible as an investment thesis: Fossil-fuel companies were living on borrowed time, in this view.
So it came to pass that divestment from the petroleum industry was viewed by some trustees, consultants and staffers as a logical thesis for pension funds that operate with a very long-term time horizon: If one expects that worsening climate trends will eventually compel adoption of alternative energy sources, then the residual value of the common stock of a fossil fuel company will be a wasting asset doomed to underperform other corporate securities.
As for the “S” in ESG investing, a similar but less provable thesis has been that companies with broadly inclusive staffing and socially conscious business practices will ultimately have an advantage over their competitors. Fans of this dimension of the ESG movement point to corporate report cards and arguably selective research on short-term or back-tested stock performance correlations. Like DEI (diversity, equity and inclusion) personnel policies and practices, the “S” in ESG investing has its natural skeptics and political adversaries, just as affirmative action has its unshakable opponents. With DEI policies becoming increasingly divisive and a Supreme Court that regularly rules with skepticism about what is disparaged as reverse discrimination, the “S” thesis is constantly under siege by social conservatives.
A Focus on the Long Term
The ESG battlefield now has two fronts: public pensions and the muni bond industry. The latter centers on the practice of blacklisting municipal bond underwriters whose companies operate ESG funds and particularly those that screen against the fossil fuel industry. Sometimes it’s just sanctions against banks that won’t lend to certain energy companies.
As you would expect, it’s the elected treasurers of oil-rich states who are leading the charge in this backlash brigade. It’s a convoluted way to punish investment managers by blackballing their completely separate and professionally unrelated bond underwriting divisions, but it is what it is: peevish retribution and grandstanding political theater. Interestingly, a few states’ legislative leaders are lately having second thoughts about the resultant higher costs of issuing municipal bonds — a boomerang on a boomerang.
Putting aside the muni bond theatrics and returning our focus to the pension world, the industry needs to find a rational way to adopt and implement ESG-relevant policies that are fiscally defensible, given the polarization of American politics that won’t go away any time soon. Pension trustees and professional staff should not be expected to endure endless criticism and catcalls for making an honest effort to invest rationally on a long-term basis in a world that is overheating, and in financial markets where sloppy corporate policies and practices are overlooked by short-sighted investment profiteers. But ESG proponents also need to abandon or at least adjust their self-righteous presumption that they have everything right.
Trustees and stakeholders deserve a thoughtful focus on long-term investment horizons, but without an evidence-based, middle-ground, politically neutral filter and lens through which to evaluate ESG investment practices and set appropriate policies, the public pension industry is doomed to endless finger-pointing, bickering, nasty polarization and wasteful litigation.
Presently, the best hope for pension trustees and staff may be research from the CFA Institute, the professional educational and credentialing association of chartered financial analysts. Without pretending to have completely solved this riddle, the institute has recently published an important research report on how to build a better ESG fund classification system. The authors postulate three distinct and discrete subsets of ESG investing in a laudable effort to avoid the frequent tendency to blur the mushy lines separating overlapping categories and criteria. Their model offers a clear grouping of ESG investment strategies that can and should be defensible for practicing money managers and public pensions — or at least provide the foundation for a more-rigorous decision framework that can meet fiduciary muster.
AI and Alternative Scenarios
There may also be a role for artificial intelligence in further refining the ESG investment decision process. It’s conceivable that part of the riddle could be solved by AI probability models that calculate the composite expected value of various investments under alternative scenarios of future outcomes in order to provide at least a quasi-scientific basis on which to hang ESG-friendly investment policies and decisions.
It’s doubtful that this alone will placate free-marketeers who hate the ESG concept in the first place, but this thought process would at least provide some logic and probability-based math in support of ESG investment actions. The problem with this line of reasoning, of course, is that if AI model forecasts prove to be worth their salt, efficient financial markets’ pricing will converge on them whichever way they point, so it risks becoming somewhat self-defeating for ESG policy advocates at the pension-portfolio level — even if they are completely right about the bigger societal picture.
Capital markets have a perverse way of disproving the “obvious” when it comes to long-term investing. Critics of social investing have enough evidence of this paradox to warrant a skeptical eye, but not a cynical blackball. In the case of ESG policies, we'll all be better off if pension trustees can put their personal politics and beliefs aside to stay focused on realistic, factually grounded investment strategies that are more than just popular presumptions and wishfully idealistic thinking. The new CFA Institute report lays sensible groundwork for such an approach. Textbook capital markets’ pricing formulas and models must stand up to empirical testing — and often have. So must ESG. As the taciturn Joe Friday, the fictional detective of the ancient TV show Dragnet, so often said, “Just the facts, ma’am.”
Governing's opinion columns reflect the views of their authors and not necessarily those of Governing's editors or management. Nothing herein should be construed as investment advice.
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