DO ESG MUTUAL FUNDS DELIVER ON THEIR PROMISES?

• Author: Curtis, Quinn
• Position: Environmental, social, and governance

Corporations have received growing criticism for contributing to climate change, perpetuating racial and gender inequality, and failing to address other pressing social issues. In response to these concerns, shareholders are increasingly focusing on environmental, social, and corporate governance (ESG) criteria in selecting investments, and asset managers are responding by offering a growing number of ESG mutual funds. The flow of assets into ESG is one of the most dramatic trends in asset management.

But are these funds giving investors what they promise? This question has attracted the attention of regulators, with the Department of Labor and the Securities and Exchange Commission (SEC) both taking steps to rein in ESG funds. The change in administration has created an opportunity to rethink these steps, but the rapid growth and evolution of the market mean regulators are acting without a clear picture of ESG investing.

We fill this gap by offering the most complete empirical overview of ESG mutual funds to date. Combining comprehensive data on mutual funds with proprietary data from the several of the most significant ESG ratings firms, we provide a unique picture of the current ESG environment with an eye to informing regulatory policy. We evaluate a number of criticisms of ESG funds made by academics and policymakers and find them lacking. We find that ESG funds offer their investors increased ESG exposure. They also vote their shares differently from non-ESG funds and are more supportive of ESG principles. Our analysis shows that they do so without increasing costs or reducing returns.

We conclude that ESG funds generally offer investors a differentiated and competitive investment product that is consistent with their labeling. In short, we see no reason to single out ESG funds for special regulation.

TABLE OF CONTENTS INTRODUCTION I. THE RISE Of ESG Mutual Funds A. The Background of ESG B. The Growth of ESG Mutual Funds C. Concerns over ESG Funds II. REGULATORY PRESSURE ON ESG FUNDS A. The SEC Names Rule B. DOE Fiduciary Duties in Retirement Plans III. EMPIRICAL ANALYSIS A. Description of Data 1. Data Sources 2. Sample Construction B. Portfolio Composition C. ESG Fund Voting Behavior D. Performance and Fees IV. IMPLICATIONS FOR REGULATORY POLICY A. The Empirical Picture B. The Pecuniary Benefits Debate C. The Puzzle of ESG Consideration Funds D. The Diversity of ESG Ratings E. An ESG-Neutral Agenda for Regulators CONCLUSION INTRODUCTION

ESG investing--that is, investing informed by environmental, social, and governance criteria or considerations--is growing explosively. (1) Public attention in the United States and globally has increasingly focused on ESG issues, (2) and a growing percentage of investors consider green investing "a big priority." (3) In one of his first official acts, President Biden rejoined the Paris Agreement, (4) and the Securities and Exchange Commission (SEC) has, for the first time, a designated policy advisor to advance ESG issues. (5)

The growing focus on ESG investing is reflected by the rapidly expanding number of mutual funds that purport to consider ESG factors in their investment and voting decisions, as well as a surge in the volume of assets invested in such funds. Morningstar reports that both the number of ESG-focused index funds and the total amount of assets held by such funds have doubled in the past three years. (6) The COVID-19 pandemic and the disruptions it has caused to financial markets have done nothing to slow this rise. (7)

But do these rapidly growing ESG funds deliver what they promise? Do ESG funds offer portfolios with real investment exposure to ESG goals or has the demand for ESG investing led to overpriced, greenwashed funds that are merely marketed as ESG to chase the latest investment fad? (8) The answers to these questions have legal implications because mutual funds are extensively regulated by the SEC and the inclusion of mutual funds in retirement plans is regulated by the Department of Labor (DOL) under the Employee Retirement Income Security Act of 1974 (ERISA) (9). In fact, both the SEC and the DOL have recently turned their attention to ESG investing. (10) For the SEC, the central legal question is whether funds that characterize themselves as focused on ESG deliver on that promise--do they invest and vote differently from other mutual funds? (11) For the DOL, the question is whether ESG investing is consistent with the fiduciary duties of retirement plan trustees--do ESG funds deliver sound performance at reasonable cost or do they sacrifice returns to promote social causes? (12) Despite these differing concerns, both the SEC and the DOL view the growth of ESG funds as potentially warranting regulatory intervention. Indeed, the DOL has already intervened, adopting a new rule on November 13, 2020, that may deter 401 (k) plans from offering ESG funds. (13) Although the SEC has not engaged in rulemaking to date, members of the Commission have expressed concerns that asset managers' current disclosure practices with respect to ESG products are insufficient. (14)

Other interventions are on the horizon as well. Asset managers' reliance on third parties, including index providers and rating agencies, in evaluating the ESG characteristics of portfolio companies has led some to call for greater regulation of those providers. (15) The Biden administration is taking steps to review and potentially replace the DOL rule, (16) and new leadership at the SEC will likely look to expand corporate disclosures to address ESG issues. (17)

These changes are taking place amid a rapidly evolving ESG landscape that has outpaced the academic literature. Instead, regulators are acting based on a variety of assumptions about how ESG funds operate, (18) often drawn from small-sample studies or anecdotal reports. (19) Even as regulators move, we know relatively little about the market for ESG funds, the investment strategies these funds use, how the funds vote their proxies, and what the funds cost. At the same time, regulatory attention has focused on ESG funds as presenting concerns distinctive from other mutual funds. But it is unclear that ESG funds, as a category, present unique regulatory issues. (20) These are all relevant policy questions that should inform rulemaking.

This Article offers the most complete empirical overview of ESG mutual funds to date. Using market-wide data on fund portfolios, voting, fees, and performance, we specifically target the concerns articulated by the SEC and the DOL. We combine detailed information on mutual funds with four proprietary datasets evaluating company-level ESG performance. Using this unique and comprehensive dataset, we explore the practical differences between ESG and non-ESG funds as well as the differences among ESG funds along four dimensions--portfolio composition, voting behavior, costs, and performance. The first two specifically target the SEC's concerns, while the latter two relate to those raised by the DOL. Our goal is to provide an overview of the market as it currently stands for the purpose of informing a regulatory push that has the potential to reshape the ESG landscape.

From the SEC's perspective, the fundamental regulatory question is what investors are getting for their "ESG dollars." We first confront the question of what ESG funds promise--the information conveyed both by the ESG label and fund disclosure practices. We then ask whether and how these funds deliver on that promise. To answer these questions, we survey the existing market and construct several categories of ESG mutual funds--funds with names that convey an ESG-oriented strategy, funds classified by Morningstar as ESG funds, and funds that purport to consider ESG factors in their investment criteria. We then analyze the portfolio composition and voting behavior of these funds to compare them across multiple dimensions. From the DOL's perspective, the primary concerns are pecuniary: What, if anything are investors giving up when they invest in ESG funds? These pecuniary costs can be direct (in the form of fees) or indirect (in the form of lower raw or risk-adjusted returns). We engage with the concerns of both regulators by providing evidence about what investors are getting and what they are giving up to get it.

Descriptively, we uncover an evolving landscape of ESG funds. Today's ESG funds range from single-issue funds that address water conservation or religious values to those that incorporate screening criteria into the construction of a broad-based index. We identify extensive disclosures of fund investment strategies--strategies that differ substantially--as well as the extent to which the fund incorporates ESG considerations into voting and engagement. We find, in short, a market that recognizes that ESG means different things to different investors.

Empirically, we demonstrate that ESG funds behave differently from other funds. We first evaluate portfolio composition. Using data from four separate rating providers, we calculate what we term a fund's "ESG tilt"--the asset-weighted average of the ESG scores of the fund's portfolio companies. Funds that identify themselves as ESG funds hold portfolios that represent a significant ESG tilt. In other words, contrary to the SEC's concern about "greenwashing," ESG funds deliver on their promise to invest differently from other funds, and their holdings are rated more highly with respect to ESG. Because we incorporate ratings from four different providers, our findings offer reassurance that funds are not "gaming" a specific ESG index.

Second, we examine fund voting behavior. Although ESG mutual funds have been criticized for not casting their portfolio-company votes in accordance with their investment profiles, (21) we document clear differences between the voting behavior of ESG and non-ESG funds. ESG funds do not automatically support every shareholder proposal...