Opinion: Biden just took a stance against the middle class

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Editor’s Note: Sanjai Bhagat is the author of “Financial Crisis, Corporate Governance, and Bank Capital,” Cambridge University Press. He is Professor of Finance at the University of Colorado. The views expressed here are his own. Read more opinion on CNN.


President Joe Biden has issued the first veto of his presidency, preserving a Labor Department rule that permits fiduciary retirement fund managers to consider climate change and social criteria when making investments.

Sanjai Bhagat

This is a mistake. By vetoing the measure to nix the rule, the President is not supporting middle class American retirees (and future retirees) or their ability to receive the highest possible investment returns to meet their retirement financial needs.

During the past decade, open-end funds and exchange-traded funds that have focused on non-traditional investment priorities — namely, environmental, social and governance factors (ESG) — have drawn considerable attention.

As of December, ESG funds had $2.5 trillion of assets under management across the globe; 83% of these assets are in Europe, 11% in the US. Investment money flowing into global sustainable funds peaked in the first quarter of 2021. During the past two years, there has been a dramatic decline in investor interest in ESG funds, especially in the US.

That’s likely because finance research has found that investor returns are generally lower from ESG investing compared to non-ESG (or traditional) investing.

In a 2019 Journal of Finance paper, researchers compared the investment performance of funds that were focused on ESG investments to funds that were not focused on ESG. Specifically, the researchers considered sustainability ratings from Morningstar — a commercial vendor of mutual fund information — for 20,000 mutual funds.

Morningstar gave funds focused on high sustainability investments “five globes” and funds focused on low sustainability investments “one globe.” Using the value-weighted market portfolio — which gives more weight to larger companies — as the benchmark, the authors found that funds with five globes underperformed funds with one globe by 5.76% annually.

Using the equal-weighted market portfolio — which gives equal weight to large and small companies — as the benchmark, they find that funds with five globes underperformed funds with one globe by 2.16% annually.

In a recent Review of Accounting Studies paper, researchers considered the investment performance of 147 self-labeled ESG funds and 2,428 non-ESG funds from 2010 to 2018. They found that the ESG funds underperformed the non-ESG funds by 1.13% annually. And in a recent Journal of Sustainable Finance and Investment paper, researchers surveyed 1,141 primary peer-reviewed papers and 27 meta-reviews (based on ~1,400 underlying studies) published between 2015 and 2020. They documented a statistically significant negative relation between ESG investing and investor returns.

To be sure, some studies have found a positive relation between ESG investing and investor returns. However, the totality of the empirical evidence from academic finance research papers suggests a negative relation between ESG investing and investor returns.

This negative relation can be understood in the context of competitive labor and product markets. In such an environment, even if corporate managers are solely focused on maximizing long-term shareholder value, they will already be focused on the well-being of employees, customers, the community and the environment. Focusing on ESG, therefore, can be redundant. Managers recognizing that their employees and customers have other options will treat their employees fairly and offer quality products and services to their customers at attractive prices.

Setting ESG targets may actually distort corporate decision making, given the problems of measuring the underlying ESG variables (for example, how should a corporation measure its commitment to diversity?) and incorporating them in an index. Distorted corporate decision-making will lead to sub-par corporate performance, and therefore, sub-par performance of ESG funds that own that company’s shares.

There is empirical evidence consistent with the notion that some companies publicly highlight their focus on ESG as a smoke-screen for their sub-par business performance. Corporate managers can declare that their primary objective is not maximizing shareholder value, but focusing on ESG.

A recent paper reports that when corporate managers underperform earnings expectations, they are likely to publicly highlight their focus on ESG. On the other hand, when their financial performance exceeds expectations, they are unlikely to make public ESG-related statements.

Hence, by investing in companies where managers publicly highlight their ESG focus, fund managers will over-invest in companies that are underperforming.

Finally, to maximize desirable outcomes such as quarterly sales per store, employee satisfaction ratings, etc., businesses use insights from optimization theory, which says that unconstrained optimization will always lead to a more optimal outcome than constrained optimization.

For example, in the context of employee satisfaction, constrained optimization (management requiring all employees to work from the office) leads to lower employee morale and satisfaction than unconstrained optimization (allowing supervisors to decide if working from home a few days a week would be fine).

Similarly, non-ESG or traditional investing (corresponding to unconstrained optimization) will always lead to a more optimal outcome (higher risk-adjusted returns) than ESG investing — or constrained investment in companies that claim an ESG focus.

President Biden is wrong to veto the Senate and House resolution, which would have required retirement fund managers to act as true fiduciaries of middle class American retirees — focusing solely on financial returns of their investments and not on environmental and social issues.