ClearBridge Investments: Incorporation of ESG is a critical part of fiduciary duty, and transparently providing clients with investment options that align with their objectives is good business and client focused.
It’s no surprise that after many years of success in both investment performance and asset gathering, environmental, social and governance (ESG) investing would face some normalization. 2022 proved to be a difficult year for ESG strategies, as many growth companies with strong ESG characteristics suffered in an inflationary and rising interest rate environment. Conversely, industries that ESG investors de-emphasize, particularly fossil-fuel-related companies, outperformed by a wide margin. In 2022, the MSCI KLD 400 Social Index of highly rated ESG companies underperformed the S&P 500 Index by over 300 basis points (bps) (Exhibit 1). In the five previous years (2017–21), the KLD 400 outperformed the S&P 500 by over 12.9% on a cumulative basis (Exhibit 2).
Sources: ClearBridge Investments, FactSet. Past performance is not an indicator or guarantee of future results. The MSCI KLD 400 Social Index is designed to provide exposure to companies with high MSCI ESG Ratings while excluding companies whose products may have negative social or environmental impacts. The S&P 500 Index is an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the United States.
Sources: ClearBridge Investments, FactSet. The MSCI KLD 400 Social Index is designed to provide exposure to companies with high MSCI ESG Ratings while excluding companies whose products may have negative social or environmental impacts. The S&P 500 Index is an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the United States.
In this environment, inflows into ESG funds have understandably slowed, although they have slowed significantly less than into other funds (Exhibit 3). From recent peak inflows in the first quarter of 2021 to the end of 2022, proportionally, flows for sustainable funds by prospectus have dropped 1.4x, while flows for other funds have dropped 3.4x.
Sources: ClearBridge Investments, Morningstar (includes U.S. open-end funds labeled “sustainable funds by prospectus,” not including money market, fund of funds or feeder funds). Past performance is not an indicator or guarantee of future results.
ESG investing has attracted attention from politicians who have attempted to delegitimize ESG as promoting a liberal agenda. During the previous presidential administration, ESG factors were targeted by the U.S. Department of Labor as being an inappropriate consideration for pension plan fiduciaries and a new rule forbid consideration of non-pecuniary factors in selecting retirement plan investments. This unsurprisingly had a chilling effect on retirement plans’ willingness to include investment strategies that incorporated the consideration of ESG factors in the investment process, in effect reducing consumer choice to invest in ESG-integrated investment products.
In November 2022 this policy was reversed by the President Joe Biden’s administration, which acknowledged that climate change and ESG factors can be relevant to risk and return analysis, and therefore are appropriate considerations for fiduciaries. Many states, however, have taken the position that ESG investing is designed to advance a social and environmental agenda, with some governors referring to it as “woke capitalism.” This politicization and hyperbolic rhetoric have caused public confusion about the merits of ESG investing and whether it is an appropriate consideration for fiduciaries. Exclusion of investment products that consider ESG analysis also serves to reduce the options that retirement plans are able to offer employees.
We hope to be able to clarify some of these questions, at least as it relates to the investment process at ClearBridge and how we approach our fiduciary duty. As a signatory of the Principles for Responsible Investment (PRI), a United Nations–founded organization promoting responsible investing, we agree with the PRI assessment that the fiduciary duties of loyalty and prudence require the incorporation of ESG issues. The three main reasons for this are: 1) ESG is an investment norm, with PRI signatories exceeding 5,000 organizations and US$121 trillion of assets under management (AUM) as of September 20221; 2) ESG issues are financially material, with general acceptance that ESG should be seriously considered in any prudent investment process; and 3) policy and regulatory frameworks increasingly require ESG incorporation, and failing to do so could lead to negative legal consequences.
In a recent article in the Harvard Law School Forum on Corporate Governance, attorney Martin Lipton, a founding partner of Wachtell, Lipton, Rosen & Katz, argues that ESG “is inherently apolitical… consideration of ESG principles is not only sensible business strategy, but also is necessary to ensure long-term sustainability and value creation, and to fulfill the fiduciary duties owed by the board and management to the corporation and to shareholders.”2 As investment managers, we similarly view incorporation of ESG as a critical part of our fiduciary duty to prudently manage our clients’ capital with the goal of long-term value creation.
Lastly, we believe transparency and providing our clients with investment options that align with their goals, objectives and values is both good business and beneficial to client outcomes. We believe offering a wide variety of investment product solutions empowers investors to choose more precisely how their capital is invested. After all, it is entirely an investor’s prerogative to decide where and where not to invest. Rather than exemplifying a pernicious “woke capitalism,” offering investment options that respond to investor demand is entirely aligned with a free market.
At the same time, the rise in popularity of ESG has led to legitimate concerns about greenwashing. New regulatory oversight that attempts— in good faith—to provide rigor and transparency to ESG investing, and to protect investors from dubious ESG claims, will enhance the maturity and long-term health of ESG investing. As a firm that has integrated ESG into the investment process for 35 years, and that manages client assets with high fiduciary standards and responsible stewardship, we welcome transparency and clear disclosure that helps clients distinguish between authentic practitioners and those with less rigor.
Endnotes
WHAT ARE THE RISKS?
Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.
Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.
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Franklin Templeton and our Specialist Investment Managers have certain environmental, social and governance (ESG) goals or capabilities; however, not all strategies are managed to “ESG” oriented objectives.
The companies and case studies shown herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton. The opinions are intended solely to provide insight into how securities are analyzed. The information provided is not a recommendation or individual investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin Templeton managed portfolio. This is not a complete analysis of every material fact regarding any industry, security or investment and should not be viewed as an investment recommendation. This is intended to provide insight into the portfolio selection and research process. Factual statements are taken from sources considered reliable but have not been independently verified for completeness or accuracy. These opinions may not be relied upon as investment advice or as an offer for any particular security. Past performance is not an indicator or a guarantee of future results.
