INDEX FUNDS AND ESG HYPOCRISY.

• Author: Chaffee, Eric C.

1. THE INTERSECTION OF INDEX FUNDS AND ESG INVESTING II. THE PROBLEMS WITH PURSUING ESG THROUGH INDEX FUNDS A. Unresolvable Conflict of Interest B. Materially Misleading C. Undemocratic III. CREATING A FUND NAME TAXONOMY FOR INVESTMENT FUNDS A. The Case for the Proposed Fund Taxonomy 1318 B. Possible Concerns CONCLUSION I. THE INTERSECTION OF INDEX FUNDS AND ESG INVESTING

   In recent years, two incompatible trends have risen to the forefront of investing. The first is the dominance of index funds (1) in allowing passive investors to gain consistent returns and mitigate risks through the diversified portfolios of these funds, which are designed to track the components of financial markets. (2) The second is the environmental, social, and governance (ESG) movement in which investors seek out socially conscious companies and try to facilitate change in companies to achieve ESG-related goals. (3)

   Each of these movements is important, which helps to explain their popularity. In regard to index funds, three entities--BlackRock, Vanguard, and State Street--have become dominant players in marketing and selling index funds. (4) As a consequence, the power of these entities is increasing rapidly and dramatically. In 2000, when combined, these three entities were the largest shareholder in 25% of S&P 500 companies, and by 2015, that number had jumped to 88%. (5) At the time of the writing of this piece, these entities currently own 5% to 7% of most public companies. (6) These numbers are only likely to increase. In regard to ESG, the ESG movement has taken root with investors, especially millennials. (7) Surveys suggests that 70% to 80% of institutional investors take ESG information into account in making investment decisions. (8)

   The tendrils of the ESG movement have reached index funds as well. BlackRock, State Street, and Vanguard have each promised to use their voting power created by their management of these funds to push forward an ESG agenda. (9) For example, in a 2020 letter to CEOs, Laurence D. Fink--Founder, Chairman, and Chief Executive Officer of BlackRock--stated that ESG has been and will continue to be a priority in BlackRock's voting practices. He wrote:

   Where we feel companies and boards are not producing effective sustainability disclosures or implementing frameworks for managing these issues, we will hold board members accountable. Given the groundwork we have already laid engaging on disclosure, and the growing investment risks surrounding sustainability, we will be increasingly disposed to vote against management and board directors when companies are not making sufficient progress on sustainability-related disclosures and the business practices and plans underlying them. (10) In a 2020 letter to clients, he made clear that these practices would be intensifying regarding index funds:

   Investment stewardship is an essential component of our fiduciary responsibility. This is particularly important for our index holdings on behalf of clients, in which we are essentially permanent shareholders. We have a responsibility to engage with companies to understand if they are adequately disclosing and managing sustainability-related risks, and to hold them to account through proxy voting if they are not. We have been engaging with companies for some time on these issues, as reflected in our engagement priorities. As in other areas of our investment functions, our investment stewardship team is intensifying its focus and engagement with companies on sustainability-related risks. (11) State Street has unapologetically chartered a similar course regarding ESG and index fund voting. State Street's Stewardship Report 2018-19 informs:

   A significant challenge for asset managers with index strategies invested in thousands of listed companies globally is to provide active oversight of their holdings. As noted, our stewardship program identifies a series of strategic priorities designed to enhance the quality and define the scope of our stewardship activities for the year. Identifying these priorities enables us to plan and actively focus our engagement efforts on thematic ESG and sector-specific issues that are important to our clients. We develop our priorities based on several factors, including client feedback received in the past year, emerging ESG trends, developing macroeconomic conditions, and the regulatory environment. (12) Finally, Vanguard has also decided to pursue ESG-related objectives through its index funds. A document from April 2019 by Glenn Booraem, Vanguard Investment Stewardship Officer, details Vaguard's approach:

   We consistently engage with portfolio companies about climate risk, especially companies in carbon-intensive industries. We believe that climate risk can potentially have a long-term impact on companies in many sectors. But our discussions on these issues are anchored to a broader conversation about governance, in particular how a company's strategy and the related risks are governed by its board. Our index funds, by design, generally hold all the companies in their benchmark; these include winners and losers, leaders and laggards. This ownership across the spectrum gives us the opportunity to influence investor outcomes by directly engaging about material environmental and social risks with directors and executives at the companies in which our funds invest. (13) Each of these statements from BlackRock, State Street, and Vanguard can be boiled down into a contradictory phrase that sounds like it belongs in George Orwell's novel, 1984: "Diversity is conformity." (11) To unpack this idea a bit more, BlackRock, State Street, and Vanguard are selling index fund shares with the promise of diversification of the portfolios that underlie those funds to stabilize returns while mitigating risk, yet at the same time, they are fueling conformity through their voting power related to those funds.

   This Essay takes the position that the importation of ESG voting into index funds by the dominate players in the index fund industry is unacceptable because it creates an unresolvable conflict of interests, is misleading to those purchasing shares in mutual funds, and is undemocratic. This Essay argues that these issues could be resolved by the SEC promulgating rules creating a fund name taxonomy to make it clear to investors the nature of the funds in which they are investing. (15)

   This Essay contributes to the existing literature in three main ways. First, this Essay contains an extensive analysis of the problems of pursuing ESG objectives through index funds, which include that it creates an unresolvable conflict of interest, is misleading, and is undemocratic. (16) Second, this Essay proposes a fund name taxonomy for investment funds to resolve the problems with pursuing ESG objectives through index funds, which includes the requirement that the title "index fund" be reserved only for passively managed funds that are designed to track the components of financial markets. (17) Such an approach would fit the underlying purposes of federal securities regulation to mandate disclosure and allow investors to make informed decisions regarding their investments. (18) Third, the analysis and proposal in this Essay is especially important because at the time of this Essay, the United States Securities and Exchange Commission (SEC) is considering whether additional rulemaking is needed relating to section 35(d) of the Investment Company Act of 1940, (19) which mandates honesty in the naming of investment funds. (20)

   The remainder of this Essay is structured as follows. Part II explores the problems of pursuing ESG through index funds. Part III examines various solutions to these problems. Finally, the last part contains brief concluding remarks.

2. THE PROBLEMS WITH PURSUING ESG THROUGH INDEX FUNDS

   Superficially, the intersection of index funds and ESG seems like a wonderful idea. For a large number of investors, the lure of relatively predictable returns with minimal risk, while pursuing ESG goals, is almost irresistible. Under the surface, however, the problems with pursuing ESG through index funds are numerous, including that such an approach creates an unresolvable conflict of interests, misleads investors as to what fund managers are actually pursuing, and produces undemocratic results. Each of these problems will be examined in turn.

   1. Unresolvable Conflict of Interest

      Attempting to achieve ESG goals by using index funds as the vehicle creates an unresolvable conflict of interests because of the essential nature of these investment devices. Index funds are constructed, advertised, and sold based upon Modern Portfolio Theory. (21) In 1952, Harry Markowitz introduced this theory in his article Portfolio Selection in The Journal of Finance. (22) In 1990, he won a Nobel Prize in Economic Sciences based upon his work on this topic. (23) Modern Portfolio Theory posits that through diversification, investors can create the greatest likelihood of consistent returns while minimizing risk. (24) A complete laying out of this theory is beyond the word limits of this Essay. With that said. Modern Portfolio Theory can be boiled down to a single word--diversification. (25) When index funds are advertised and sold to investors, fund managers are selling individuals the ability to diversify their portfolios through a single investment device. (26) The financial market that the index fund tracks will have certain criteria to be a part of it. (27) For example, an index fund that tracks the S&P 500 would have only large companies in its portfolio. (28) but the goal remains diversification. (29) Importantly, diversification is a means, not an end. The end of Modern Portfolio Theory is profit. (30)

      In regard to ESG investing, the goal is dramatically different. The ESG movement is a form of principle-based investing, which employs various ESG factors in investment practices. (31) As a result, ESG investors seek to...