SEC proposals for ESG ignore 80 years of financial science
The first change proposed by the SEC is to apply the “80% rule” to funds whose names suggest an ESG focus, which means that 80% of the value of the fund’s assets must be made up of assets described by name. But for the past 70 years, modern portfolio theory has dominated finance. You do not evaluate securities individually; you look at the statistical properties of the portfolio as a whole.
This idea is clearer with international equity funds than with ESG. By the late 1980s, foreign stocks were strongly outperforming US stocks, so foreign stocks and international stock mutual funds became popular. The easiest way to make an equity fund international was to buy large-cap multinational companies headquartered in Europe, Japan, or elsewhere. But these companies were influenced by the same economic fundamentals as large-cap US multinationals, so the resulting funds had high correlations to the S&P 500 Index, often higher than most US equity funds.
What investors wanted was not a high proportion of fund assets in companies domiciled outside the US, they wanted a low correlation to the S&P 500 for diversification and a high correlation to stock markets. foreigners because they were doing well. This was more difficult to achieve because it meant going to foreign stock markets, analyzing companies that used unfamiliar accounting principles and whose documents were not always available in English, working with foreign banks and brokers, understanding differences in jurisdictions, etc. , you found that there were US-domiciled companies with high exposure to foreign equities and foreign-domiciled companies with little exposure to foreign equities. The optimal portfolio balancing S&P 500 correlation, foreign equity correlation and expected return could contain more than 20% US-domiciled stocks.
The SEC proposal assumes a “Santa Claus” strategy. You make a list of naughty and nice actions and make sure that 80% of your choices come from the nice list. But it’s a silly way to advance ESG goals (and I don’t think it’s very good at getting kids to behave either). I’ve spent a lot of time talking to investors who are concerned about ESG and what most of them want is an overall portfolio that will make the world a better place and generate profits as the world gets better. They want to be exposed to an “ESG factor”, not 80% of their money in Nice certified companies.
The 80% rule doesn’t actually require a Santa strategy. A manager could use a dynamic portfolio strategy and argue that 80% of assets were directed towards the strategy’s objective. But it’s expensive and risky, and most managers won’t do it. The SEC blocks innovation not just by banning things. There was no law against innovations such as money market funds and index funds, but people who tried to offer these things were frustrated for years by the SEC’s finicky objections and procrastination. . Moreover, they needed determination and courage because many of them went bankrupt or were hit with regulatory penalties.
The other SEC proposals relate to disclosure. A major problem – which I hope will be corrected during the comment period – is that the obligations of “scope 3” go far beyond public companies and apply to all companies with which they do business. Nestlé can fill out long forms about its carbon emissions at a cost that represents a negligible fraction of its revenue. But a farmer selling crops to Nestlé might find filing these disclosures extremely costly. The most fundamental problem is that disclosure assumes a top-down perspective. Investors decide what is good and bad for ESG and instruct their managers, managers tell business leaders what to do, who tell their employees and suppliers. The purpose of disclosure is for investors to ensure that employees and suppliers ultimately follow orders.
The problem with this Soviet-style command economy is that investors lack the information and expertise to make the billions of decisions the economy demands every day. Balancing the many environmental, social and governance goals – while realizing profits – is incredibly difficult and cannot be achieved by distant, untrained retail investors with uniform principles.
The right approach to improving ESG is to use incentives. Investors should reward managers for achieving objective and demanding performance and ESG goals. Managers should reward companies, and companies should reward employees and suppliers. Don’t tell a purchasing manager whether to buy a more energy-efficient product or a product made by a minority-owned company, find a purchasing manager who cares about the environment and social justice, and make his bounty dependent on his overall success in improving these things.
I don’t claim it’s easy. Incentives can be manipulated and can attract people who only care about the money, not the underlying issues. Thus, investment managers must work hard to find companies with real ESG cultures, reward them with cheaper capital, and encourage them to design appropriate incentives. It is expensive and probably requires concentrated positions, activism, leverage and derivatives to increase influence. It’s much harder to do if you have to disclose everything and offer daily cash. Investment managers will only do this if they are in turn rewarded with performance fees based on both ESG and performance.
All of this is impossible in a public mutual fund. Public mutual funds are only allowed to charge management fees, so the only way for them to increase their income is to have more assets under management. They are very good at gathering assets under management, but as a group pick stocks that are worse than random picks. Relying on people who can’t even pick average stocks — the relatively simple goal of finding companies with average or better returns on equity — to save the world is foolish.
My suggestion for the SEC is to create a new class of investment funds, open to retail investors, with relaxed financial rules in exchange for an ESG focus. Enable monthly rather than daily liquidity and reduce asset disclosure requirements. Relax rules on mergers, leverage, derivatives and activism. Allow performance fees for funds that achieve both objective and documented ESG performance and objectives measured by independent third parties. The best thing for the SEC to do is to get away from the innovators, not add new layers of regulation to get in the way of them.
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Aaron Brown is a former Managing Director and Head of Capital Markets Research at AQR Capital Management. He is the author of “The Poker Face of Wall Street”. He may have an interest in the areas he writes about.
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