Scrutinizing high ESG fees, greenwashing and the politicization of public pension funds

Environmental, social, and governance (ESG) assets are expected to top $50 trillion worldwide by 2025, according to Bloomberg Intelligence. The latest report from the Global Sustainable Investment Alliance put “sustainable” investments at 36% of professionally managed assets globally. However, despite this rapid growth, ESG-focused investing is drawing criticism, even from some supporters, due to overstated claims and high fees. In the public sector, ESG implementation is increasingly seen as a politicization of public dollars.

Greenwashing and Marketing

Both Goldman Sachs and Deutsche Bank’s DWS are currently facing U.S. Securities and Exchange Commission (SEC) probes over the alleged “greenwashing” of their investment funds, according to The New York Times. Greenwashing is a term used to describe firms or investment funds that make unsubstantiated or misleading claims to appear more environmentally and ESG-friendly. The Times reports:

ESG reporting has emerged as a top priority for the SEC under the agency’s chair, Gary Gensler. Earlier this year, the commission proposed changes that would require more disclosure from companies to investors about the risk that climate change and new government policies on it might pose to their operations. And last year, the regulator set up a special ESG task force to focus on whether Wall Street firms and companies were misleading investors about their investment and business criteria in the environmental, social and governance area.

The investigation into Goldman’s mutual funds appears to be related to the new enforcement initiative. Last month, the investment advisory arm of Bank of New York Mellon paid $1.5 million to settle an investigation by the SEC. into allegations it had omitted or misled investors about its ESG criteria for assessing investments. The SEC is also looking into Deutsche Bank.

The Deutsche Bank/DWS investigation may be related to whistleblower Desiree Fixler’s claims that ESG assets under management were inflated. Fixler told the Financial Times, “I still believe in sustainable investing, but the bureaucrats and marketers took over ESG and now it’s been diluted to a state of meaninglessness.”

Last year, Tariq Fancy, the former head of sustainable investing at BlackRock, questioned the legitimacy of ESG investments in an op-ed for USA Today:

I led the charge to incorporate environmental, social and governance (ESG) into our global investments. In fact, our messaging helped mainstream the concept that pursuing social good was also good for the bottom line. Sadly, that’s all it is, a hopeful idea. In truth, sustainable investing boils down to little more than marketing hype, PR spin and disingenuous promises from the investment community.

Consistent with Fancy’s claim that ESG is little more than “PR spin,” many other critics contend the ESG signaling and actions from some of the largest asset managers are partly attempt to attract younger investors—who may be attracted by the idea of “socially conscious” investing. A Southern California Law Review paper by Michal Barzuza, Quinn Curtis, and David Webber in 2019 argues that:

…index funds must seek out differentiation in the market where they can find it. Using their voting power to promote their investor’s social values, and doing so publicly and loudly, is a way for these funds, which otherwise risk becoming commodities, to give millennial investors a reason to choose them.

Higher Fees For ESG-Related Funds

The asset management industry has experienced declining management fees since the 1990s, in what is commonly referred to as “fee compression.” A July 2022 analysis from Morningstar showed that for asset-weighted passive funds, fees have “declined 66% since 1990.”

But in many cases, ESG investments are proving to be an opportunity for funds to charge higher fees. The Economist looked at three very similar exchange-traded funds (ETFs) managed by BlackRock: Core S&P 500 (IVV), ESG Screened S&P (XVV), and ESG Aware MSCI USA (ESGU). Despite very similar composition and synchronized performance in 2022, the ESG ETFs had 2.7 to 5-times higher expense ratios, the percentage of a fund’s assets used to cover operating expenses.

Whether this difference is due to the relative size of these funds and the back-end work involved in constructing the index, it is a persistent pattern. In 2021, Morningstar found a significant so-called “greenium” upcharge for ESG funds. While Morningstar found fees were at record lows in 2021, the asset-weighted average expense ratio was 0.55% for sustainable funds—significantly higher than 0.39% for traditional funds.

Politicizing Public Pensions and Taxpayers’ Dollars

Higher fees and marketing strategies are not parts of the environmental, social, and governance-related sales pitches made to investors. Instead, ESG advocates and asset managers make the case that environmental, social, and corporate governance considerations are in the best interest of investors. BlackRock CEO Larry Fink, for example, wrote in his 2022 letter to “CEOs and chairs of the companies our clients are invested in”:

Stakeholder capitalism is not about politics. It is not a social or ideological agenda. It is not ‘woke.’ It is capitalism, driven by mutually beneficial relationships between you and the employees, customers, suppliers, and communities your company relies on to prosper.

Despite Fink’s framing, ESG policies often take sides on some of the most contentious contemporary political issues, including energy, environmental policy and climate change, foreign policy, abortion, guns, workplace issues, and more. ESG often moves these issues from legislative, judicial, and political spheres into financial markets and corporate boards, increasingly politicizing what might previously have been non-political organizations and institutions focused on their core missions and products.

To claim otherwise presupposes that ESG considerations are an objectively better way to operate and evaluate firms. Thorough analyses, like research by the University of California-Los Angeles Professor Bardford Cornell and Aswath Damodaran, a professor at New York University, concluded: “evidence that investors can generate positive excess returns with ESG-focused investing is weak.”

Still, to be clear, private individuals and institutions are free to allocate their assets in whatever ways they see fit. Public sector financial assets are a different story. Public pension funds have a fiduciary duty to manage assets in ways that ensure the funds can meet the retirement needs of their members. For public pension systems, political activism of any stripe, as my Reason Foundation colleague Richard Hiller notes, is “inconsistent with these fiduciary responsibilities and retirement plan objectives.”

The over $5 trillion in state and local public pension investment assets should not be treated as money that is up for grabs or that can be leveraged for political causes by politicians, system administrators, and subgroups of plan participants. Unfortunately, however, government entities across the board are increasingly becoming activists on political issues.

On ESG, two major groups in climate activism are the Ceres Investor Network and Climate Action 100+. Eleven public pension plans, eight state treasurer offices, and three state investment boards have signed on as members of Ceres, which describes itself as “a nonprofit organization transforming the economy to build a just and sustainable future for people and the planet.”

Similarly, 16 public pension plans, three state treasurer offices, and four state investment boards are members of Climate Action 100+, which says it “is an investor-led initiative to ensure the world’s largest corporate greenhouse gas emitters take necessary action on climate change.

A report from Morningstar found that public pension funds supported ESG shareholder resolutions at a greater rate than ESG-focused funds in 2021. Among key ESG shareholder resolutions in 2021, the report found:

Perhaps not surprisingly, public pensions based in Democratic-leaning states tended to vote in favor of ESG resolutions more often than those based in Republican-leaning states—the former had an average 98% support rate across public pension funds compared with the latter's 80%. Public pensions located in split states landed in between, at 85%. The less predictable outcome may be that all three groups came out well ahead of general shareholders' average 63% rate of support across key shareholder resolutions and didn't look too different from the 85% rate of support seen from ESG-focused funds.

The report also found that policymakers and taxpayers should: “Insist that public pension funds provide better transparency on their voting policy, votes, and voting rationale.”

As the financial industry receives increased scrutiny related to its ESG practices and likely inflated claims, the involvement of public pension systems becomes better known, and some politicians push to make ESG-related investments and issues mainstream public issues, there could be a reckoning ahead. Given the size of the ESG asset management industry, ESG investments and practices are likely to continue to be a significant part of financial markets and the business world for the foreseeable future. However, all parties involved should embrace a serious review of existing approaches and increased transparency, especially when it comes to public pension systems and taxpayers' dollars.