Labor Dep. Delivers ‘Boost for US Responsible Investing’

US institutions’ use of social and environment-oriented investment strategies could accelerate following guidance issued by the Department of Labor (DOL), according to consulting firm Callan Associates.

“These factors… are proper components of the fiduciary’s analysis of the economic and financial merits of competing investment choices.”Last month the department published an “interpretive bulletin” acknowledging that environmental, social, and governance (ESG) factors “may have a direct relationship to the economic and financial value of an investment.”

“When they do, these factors are more than just tiebreakers, but rather are proper components of the fiduciary’s analysis of the economic and financial merits of competing investment choices,” the DOL stated.

A survey of US institutions by Callan showed a rise in the portion of investors incorporating ESG factors into their decision making, from 22% in 2013 to 29% this year. Callan’s survey report noted that the DOL’s clarification “could affect future survey results.”

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“As sustainable investing and ESG factors have gained interest globally, investors in the US have been slower to adopt these types of frameworks into investment decision making than counterparts in Europe, Australia, and other developed nations,” Callan said.

While Australia and many countries in Europe have explicit ESG requirements for institutional investors, Callan said “a large part” of the US’ investment community had previously interpreted existing guidelines “as a barrier to incorporating ESG into the investment framework.”

Callan’s survey showed that endowments and foundations were leading the way in ESG investing: 37% of endowments and 39% of foundations explicitly include the considerations in their processes, up from 22% and 31% respectively two years ago.

Nearly a third (29%) of US institutional investors overall—including corporate and public pension plans—incorporated ESG lenses into asset management, up from 22% two years ago.

The survey also found 11% of investors yet to incorporate the factors were considering doing so.

Other research published this week has found that ESG investing is continuing to gain traction across the globe.

More than half of investment consultants polled by research firm Cerulli said they had dedicated ESG resources within their manager research teams, with another 20% saying they plan to add the capability.

Among European institutions, 61% were planning to increase investment in “renewable infrastructure” in the next three years, according to asset manager Aquila Capital. Investors cited diversification, long-term cash flows, and prospective returns as the primary reasons for expanding their exposure. Only one fifth (22%) called environmental concerns the number one motivator.

Recently, German insurer Allianz has announced plans to sell roughly €4 billion ($4.2 billion) of coal investments and reallocate the capital into renewable energy sources, such as wind.

In addition, this week saw Sweden’s six state pension funds announce they had aligned their carbon-monitoring processes. All funds have released data on the carbon outputs from their investment portfolios in 2014, and in the future will coordinate these reports.

Indexes are becoming more than just market-cap-weighted portfolios, according to a new report from MIT.

“A confluence of technological advances has caused tectonic shifts in the financial landscape, creating winners and losers overnight.”With new passive investment products continuing to emerge, Sloan Professor of Finance Andrew Lo proposed broadening the definition of an index to include “dynamic indexes” such as smart beta strategies.

Indexes, he argued, should include any portfolio strategy that is completely transparent, investable, and rules-based. Dynamic indexes are any portfolio that fits this definition but is not market-cap weighted.

Instead, the dynamic indexes are weighted according to other factors—and not just value or momentum, according to Lo’s definition. Target-date and life-cycle funds, for example, change their asset allocations as they approach target dates, while hedge fund replication strategies replicate the betas of entire classes of hedge funds.

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The distinction is important, according to Lo, because dynamic indexes may contain more “subtle” risks, such as tail, illiquidity, or credit risk.

“Passive investing need not, and should not, imply passive risk taking, as it currently does,” Lo wrote. “If used properly, dynamic indexes can greatly benefit both investors and portfolio managers by allowing them to construct more highly customized portfolios that can achieve long-run investment objectives by managing short-run risks more effectively.”

But while the new brand of indexes can be used to an investor’s advantage, they also pose new challenges: The sheer number of financial products available requires greater education and training to evaluate potential risks and returns.

More importantly, the rise of smart beta leaves investors and portfolio managers exposed to misleading backtest bias.

“The number of new products is growing rapidly, and because, by definition, new products do not have live track records, estimates of their performance can only be based on simulated returns and are, therefore, noisier than for more-established products,” Lo wrote.

“Because simulations are, for many of these new products, the only way investors can develop intuition for the products’ risk/return profiles, decisions tend to rely much more heavily on biased performance statistics,” he continued.

When investing in smart beta indexes, therefore, Lo recommended treating all investment performance records with a “healthy dose of skepticism,” and using additional information and live-out-sample experiments to distinguish between luck and skill.

“A confluence of technological advances has caused tectonic shifts in the financial landscape, creating winners and losers overnight,” Lo concluded. “The winners are technology-savvy investors who understand their own risk preferences and financial objectives, and can appreciate the full spectrum of risks and rewards offered by today’s dizzying array of smart-beta and index products.”

Lo’s paper, “What is an Index?”, can be downloaded from SSRN.