Should ESG funds be in retirement plans?

Yet, odds are most people won’t find an ESG fund option in their 401(k) retirement-savings plan. Just 2.6% of 401(k) plans had an ESG option in 2019, according to the latest data from the Plan Sponsor Council of America.

Amid lobbying from Wall Street, the Labor Department this year declined to enforce a Trump-era rule that would have made it harder to add ESG funds to retirement accounts. Whether and when more definitive guidance is coming remains to be seen.

Proponents say there is no good reason to keep ESG funds out of 401(k) plans. Opponents say adding such funds to 401(k)s would be a breach of fiduciary responsibility because there is no global standard for defining and measuring ESG performance.

YES: Eager investors shouldn’t be denied

By Aaron Yoon

Offering employees the option of investing in environmental, social and governance (ESG) funds in their 401(k) retirement-savings plans is essential. If individuals are making clear that they want the option to invest this way, there is no good reason to deny them the opportunity to do so in their 401(k) accounts.

Overall demand for ESG investing is growing. According to fund researcher Morningstar Inc., a record $51.1 billion flowed into U.S. sustainable funds in 2020, more than double the amount in 2019 and nearly 10 times the total for 2018.

The argument that ESG funds serve only a “feel good" purpose, but don’t produce adequate returns, is a misconception. Research that I conducted with colleagues showed that firms with good ratings on “financially material" ESG issues—that is, ESG issues that are relevant to the sector in which a company operates—deliver superior stock returns. Similarly, an analysis from S&P found that from March 2020 through March 2021, 19 ESG-themed exchange-traded funds and mutual funds with more than $250 million in assets under management outperformed the S&P 500 by anywhere from 0.2 to 27.9 percentage points.

Clearly, not only is ESG a bona fide investment strategy, but the growing demand means adding such funds to 401(k) lineups might even encourage more people to participate in their employer-sponsored retirement-savings plan.

That said, choosing ESG funds wisely can be a challenge. Articles abound about “greenwashing" by companies that purport to be eco-friendlier or more sustainable than their actual activities would attest. Among ESG funds, there are those that have a mandate to construct sustainable portfolios, while others have merely been relabeled to catch the green wave.

Some critics say the lack of transparency around ESG funds is a reason these investments should be excluded from 401(k) plans. I believe the opposite is true. Including ESG funds in 401(k) plans likely would increase pressure on fund companies and regulators alike to improve transparency, resulting in long-awaited standards and reporting rules around what makes an investment sustainable.

Fund managers and investment firms need to be more forthcoming in how they quantify ESG objectives and sustainability among the stocks and other assets in their portfolios. They also have to be transparent about the fees they charge and justify any premium. Just because fees for ESG funds have decreased in recent years doesn’t mean fund managers can skimp on stock picking or communicating their investment strategy.

Regulators need to act, too, by requiring greater transparency, especially around fund managers’ investment criteria. The United Nations Principles for Responsible Investment (UNPRI), which requires signatories to file a transparency report at the end of each year on their ESG investing practices, was a good first step. But other research I conducted with a colleague found that only a small number of funds actually improved their ESG scores after joining the UNPRI, while the rest simply used their status to attract capital.

A bit more promising is the European Union’s Sustainable Finance Disclosure Regulation (SFDR), which sets rules for the sustainability-related information that financial firms must disclose. The U.S. Securities and Exchange Commission is quickly playing catch-up, and is expected to take up ESG disclosure, as well, even if only for the simple fact that investors want and need these standards to help them make decisions.

This is where 401(k) plans can make a significant impact by including ESG funds in their investment choices. Not only would including ESG funds in 401(k) plans be a big step forward in making ESG even more mainstream and credible, it would increase the need for standards in this space. That would be good not only for 401(k) plans in determining the best fund choices, but it will also provide much-needed transparency for all investors who want to put their money into ESG.

Prof. Yoon is an assistant professor of accounting & information management at the Kellogg School of Management at Northwestern University. He can be reached at reports@wsj.com.

NO: There’s too much confusion about them

By Phillip Braun

When companies provide employees with 401(k) retirement accounts, they assume a fiduciary responsibility that the funds being offered within these plans live up to their descriptions.

For some funds—such as passive funds that replicate the performance of indexes such as the S&P 500, Nasdaq-100, or Russell 2000—this is fairly straightforward. It is far less clear, however, that funds that purport to advance environmental, social and governance (ESG) objectives actually achieve their goals.

The problem with ESG funds stems from the fact that there is no global standard for defining and measuring ESG performance, and that has led to a great deal of confusion. Therefore, adding ESG funds to the mix of 401(k) investment options would only further compound the investment challenge for the nearly two-thirds of people who say they don’t fully understand 401(k) plans in the first place.

Admittedly, ESG investing is hot right now. According to a Bloomberg analysis, total global ESG assets under management could reach $53 trillion by 2025, equivalent to more than one-third of projected global assets under management of $141 trillion. In the U.S., a Morningstar Inc. report showed that capital inflows into ESG funds reached $51.1 billion in 2020—more than double the inflows of $21.4 billion in 2019 and accounting for 24% of overall flows into U.S. stock and bond funds last year.

With more attention being paid to ESG investing, it is logical to assume that 401(k) plan participants would find such investment options appealing. The danger, however, is that they may equate popularity with outperformance, and that simply isn’t the case. The evidence indicates that, on average and on a risk-adjusted basis, ESG funds perform as well as their benchmarks—but neither better nor worse.

At the same time, ESG funds tend to be more expensive than other funds. According to another Morningstar study, the asset-weighted average expense ratio of U.S. ESG funds was 0.61% in 2020, compared with 0.41% for all U.S. open-end mutual funds and ETFs.

Even small differences in expense ratios can add up over time. For example, according to my calculations, a $100,000 investment portfolio with an 8% annual return would increase to about $898,000 over 30 years with an expense ratio of 0.41%, versus about $849,000 if the expense ratio was 0.61%—a difference of $49,000.

This raises the question: If ESG funds on average don’t deliver outperformance, yet are more costly than other funds, what are investors paying for?

Even those who are willing to pay extra to support sustainability and a “green" agenda cannot be sure that ESG funds deliver on that either. The issue is whether a highly rated ESG company actually has a sustainable impact on the environment or society. In other words, does a company actually “do good" by pursuing sustainability as it seeks to “do well" financially? This discernment problem compounds as stocks are aggregated into funds and then across the funds themselves.

Determining whether a stock or a fund is truly advancing ESG goals is difficult because the investment industry lacks a comprehensive ESG measurement framework. There are attempts to clarify things such as the Sustainable Finance Disclosure Regulation (SFDR) in Europe, which obligates investment managers to explain how they account for ESG and other factors as part of their portfolio selection process. But no such criteria has been implemented in the U.S. and beyond, leaving investors to wonder about the sustainability of their investments—and if that pursuit of sustainability improves performance.

Against this backdrop, do companies really want to offer their employees ESG funds in their 401(k) retirement accounts? Currently, ESG investing seems more like a fad than a rational investment option. Given the continuing confusion and lack of clarity over what constitutes ESG investing and its impact on both fund performance and ESG impact, doing so would appear to breach a company’s fiduciary responsibility to its 401(k) enrollees.

Prof. Braun is a clinical professor of finance and associate chairman of the finance department at the Kellogg School of Management at Northwestern University. He can be reached at reports@wsj.com.