Why Add ESG Funds to Your Investment Menu?

An increasing number of investors want impact-driven investment vehicles. They want to avoid investing in companies that avoid diversity and inclusion, abuse labor, produce products or provide services that cause health or safety problems, or pollute the environment. However, trying to bypass such companies can make investing in many mutual and index funds a challenge. Because of this, environmental, social, and governance (ESG) funds are increasing in popularity, especially among younger investors. According to a survey conducted by Callan Institute, incorporation of ESG factors into the investment decision-making process increased to 42% in 2019 compared to 22% in 2013. But is it cost-effective and a good fit to include ESG funds in your plan’s investment menu? Learn more about ESG and how you should proceed if you’re interested in adding ESG funds to your investment line up.

What is ESG Investing?

ESG investing isn’t a new concept—for decades, there have been funds that deliberately avoid companies whose products could be seen to pose a “moral hazard” (particularly liquor and tobacco stocks) and conflicted with investor’s values. These types of funds were referred as “SRI,” or socially responsible investing, but today’s ESG funds are much broader and encompass a wide range of eco-friendly, transparent, and socially conscious investments.

For example, some ESG funds include only companies that have committed (either in their mission statement or bylaws) to reducing energy usage or adopting a “zero waste” policy. Others focus on responsible corporate governance, companies that seek to establish and maintain gender and ethnic diversity or that are committed to fair pay for employees and executives.

ESG investing can include index funds and actively managed funds.

Benefits of ESG Funds

Offering ESG funds as part of your investment portfolio comes with a couple of key benefits.

Greater Employee Participation

The oldest cohort of the millennial generation is about to turn 40, which means investing for retirement is no longer such a remote prospect. But while a percentage of millennials say that they’re saving for retirement, nearly half of this group is investing in conservative funds like cash or bonds—neither of which have nearly the growth potential of stock funds. In addition, these funds are particularly attractive to millennials. Thus, including funds that align with their personal values can be a way to encourage reluctant millennials to start saving for retirement. Adding ESG funds to your retirement plan can generate buzz, increase participation, and draw investors away from more conservative funds that may not achieve the returns they need.

Improved Returns

ESG principles aren’t just “feel good” ideals—many conservation and equality efforts can improve a business’ bottom line. By boosting revenue or cutting overhead costs, companies that are committed to ESG principles can offer competitive investment returns. And as ESG becomes more popular, more companies are likely to jump on this trend, offering diversification and giving plan sponsors more quality options from which to choose.

Risks of ESG Funds

Despite their benefits, these funds aren’t without some risk. Not all funds are created equal, and not every fund that carries the “ESG” label actually abides by ESG principles. Further, some ESG funds (especially newer ones with less track record) may be more volatile than established funds, and sustaining losses in these funds can discourage employees from future plan participation.

Fiduciaries and plan sponsors must still carefully evaluate any funds they plan to add to their retirement plan offerings to ensure that they reflect the values set forth in your investment policy statement (IPS).

Evaluating Your Next Steps

Plan sponsors who wish to add ESG options to their retirement plan offerings should take a few preparatory steps.

First, talk to your plan’s investment advisor who can provide some insights on specific funds that offer strong metrics and solid past performance. Because so many companies have recently committed to various ESG principles, sorting through and rating these funds on your own can seem like an overwhelming task.

Next, consider how many funds you’d like to add to your plan—and whether this may mean replacing funds you already have. The U.S. Department of Labor (DOL) has issued some ESG guidance to fiduciaries, cautioning them about over-emphasizing these funds’ commitment to ESG principles. With this in mind, it may be better to ease into ESG investing by offering just one or two high-quality funds at first, monitoring performance and participation, and then re-evaluating in another year or two.

You’ll also want to update your Investment Policy Statement to include any new criteria that will be used to evaluate ESG investments. By having standards and procedures in writing, you’ll help fulfill your fiduciary obligations to plan participants.

Finally, you’ll need to communicate these new investment options to plan participants, many of whom may know nothing about ESG funds or principles. It’s a good idea to provide this communication before these investment options become available; this can give you some lead time to answer questions or address any concerns before the funds go “live”.

Let PlanPILOT Help

ESG funds can provide value to plan sponsors and participants alike, boosting plan participation while maintaining solid returns. But not all ESG funds are a good fit for every retirement plan, and plan sponsors must still remain vigilant of their fiduciary obligations. If you have questions about how you can incorporate environmental, social, and governance funds into your investment me, we’d be glad to meet with you and discuss. Give our office a call at (312) 973-4911 or email us at info@planpilot.com.

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