Trustees of pensions, university endowments and trust funds are facing renewed pressure to do social good while investing other people’s money. It isn’t only student activists but the United Nations and even
CEO Larry Fink who argue that environmental, social and governance investing, or ESG, will do good for the world while improving returns for beneficiaries. Thousands of investment managers have pledged to abide by a U.N.-sponsored statement of ESG principles.
Yet the zealous push for fiduciaries to embrace ESG faces barriers under longstanding American law—with good reason. In general, the law says little about what people may do with their own money. But it has much to say about what trustees and other investment fiduciaries do with their beneficiaries’ money.
By law, a trustee must abide by fiduciary duties of loyalty and prudence, and therefore act for the “exclusive” benefit of the beneficiaries, considering “solely” their interests, without regard for collateral benefits, such as advancing social or environmental causes. A trustee must also invest with risk-and-return objectives reasonably suited to the beneficiaries, adjusting the portfolio as circumstances change. If an investment strategy stops working or a better strategy becomes available, a trustee must change accordingly.
Before the 1990s, proponents of socially responsible investment largely appealed to investors’ ethical, moral and social responsibilities to others. But considering collateral benefits to third parties violates the “sole interest” rule under U.S. trust fiduciary law. The fiduciary duty of loyalty rules out this form of socially responsible investing.
Accordingly, proponents of social investing rebranded it around the turn of the century. First, they recast the movement as “ESG” by adding the “G,” corporate governance, which had long been considered by profit-seeking active investors. Second, the U.N.-sponsored Principles of Responsible Investing, or PRI, joined proponents in claiming that ESG investing could improve risk-adjusted returns, pointing to a raft of empirical studies.
Instead of avoiding the fossil-fuel industry for environmental benefits, for example, ESG proponents argued that reduced exposure to fossil fuels would improve returns because the market underestimates the litigation and regulatory risks associated with such investments. ESG investing for risk-and-return benefits instead of collateral benefits turned social investing into an active, profit-seeking investment strategy. Thus the PRI declared in 2015 that fiduciaries are under “positive duties . . . to integrate ESG issues.”
The PRI’s position that a fiduciary must use ESG factors is flawed as a matter of both law and finance. To begin, ESG factors are highly subjective. ESG ratings services disagree, for example, about whether Tesla or Exxon is a better bet. Moreover, fiduciary law doesn’t mandate any particular investment strategy. A fiduciary can choose any plausible strategy, active or passive, as long as the fiduciary is motivated solely by a reasonable belief that the strategy will improve risk-adjusted returns.
The same logic that motivates a risk-return ESG strategy could support an anti-ESG investment strategy. If a fiduciary reasonably concludes that ESG factors have become overvalued, perhaps because of the zealous advocacy of PRI and BlackRock, the fiduciary could make the opposite bet, preferring fossil fuels, tobacco and other such “sin stocks.” To mandate a fiduciary investment strategy on the theory that companies with high ESG scores will be perpetually undervalued runs contrary to everything we know about capital markets.
There is some empirical support for risk-return ESG investing. But advocates have oversold the evidence. Even if an ESG factor has a relationship to an investment’s performance, it doesn’t follow that the market has mispriced that relationship. The evidence on the profitability of ESG investing is mixed and contextual, and will likely change, especially as markets adjust to the growing use of ESG factors. Risk-return ESG investing can be consistent with fiduciary duty, but it is not automatically so, and contrary to the PRI, it is certainly not mandatory.
Everyone wants to have his cake and eat it, too. But for a trustee, facts and motives matter. For a pension fiduciary, the Supreme Court says this means focusing exclusively on “financial benefits.” A fiduciary needs to have a reasonable factual basis for believing that an investment strategy satisfies that requirement. And the fiduciary may not use other people’s money to pursue collateral benefits to third parties, no matter how well-intentioned.
Mr. Schanzenbach is a professor at Northwestern Pritzker School of Law. Mr. Sitkoff is a professor at Harvard Law School.