Do ESG Mutual Funds Deliver on Their Promises?

Quinn Curtis is Albert Clark Tate, Jr., Professor of Law at the University of Virginia School of Law, Jill Fisch is the Saul A. Fox Distinguished Professor of Business Law at the University of Pennsylvania Law School, and Adriana Z. Robertson is Honourable Justice Frank Iacobucci Chair in Capital Markets Regulation and Associate Professor of Law and Finance at the University of Toronto Faculty of Law. This post is based on their recent paper. Related research from the Program on Corporate Governance includes Companies Should Maximize Shareholder Welfare Not Market Value by Oliver Hart and Luigi Zingales (discussed on the Forum here); and Reconciling Fiduciary Duty and Social Conscience: The Law and Economics of ESG Investing by a Trustee by Max M. Schanzenbach and Robert H. Sitkoff (discussed on the Forum here).

ESG investing is growing explosively, and the interest in ESG investing by retail investors continues to increase. A substantial proportion of retail ESG investing occurs through ESG mutual funds. The number of ESG mutual funds, and the assets they hold have each doubled in the past three years, and the COVID-19 pandemic has done nothing to slow this trend. But does this rapidly growing sector of the investment industry actually deliver investment exposure to ESG goals, or has the demand for ESG investing led to overpriced, greenwashed funds that are merely marketed as ESG to chase the latest investment fad or extract higher fees from investors? While these concerns have attracted attention from both the Securities & Exchange Commission (“SEC”) and the Department of Labor (“DOL”), much of the regulatory conversation to date has relied on theoretical concerns and anecdotal evidence. This, combined with the rapidly evolving market for ESG funds, demonstrates the compelling need for greater empirical analysis directly targeting the regulators’ concerns.

Our paper provides that evidence. Using market-wide data on fund portfolios, voting, fees, and performance, we specifically target the concerns articulated by the SEC and the DOL. We combine detailed information on mutual funds with four proprietary datasets evaluating company-level ESG performance: ISS, S&P, Sustainalytics, and TruValue Labs. Using this unique and comprehensive dataset, we explore the practical differences between ESG and non-ESG funds as well as the differences among ESG funds along four dimensions—portfolio composition, voting behavior, costs, and performance. Our goal is to provide an overview of the market as it currently stands for the purpose of informing regulatory initiatives that have the potential to reshape the ESG landscape.


Speech by Commissioner Roisman on Whether the SEC Can Make Sustainable ESG Rules

Elad L. Roisman is a Commissioner at the U.S. Securities and Exchange Commission. The following post is based on his recent speech. The views expressed in this post are those of Mr. Roisman and do not necessarily reflect those of the Securities and Exchange Commission or its staff.

Thank you Gary [LaBranche] and the National Investor Relations Institute for inviting me to speak at your 2021 Virtual Conference. Of course, I will clarify up front that the views I express are my own and do not necessarily reflect those of the Commission.

I. Introduction

I appreciate the unique and important role Investor Relations (“IR”) teams play in our capital markets, serving as a primary channel for communication between companies’ leaders and groups such as analysts, as well as asset managers and investors who hold ownership positions in those companies. It seems that an increasing amount of that communication involves environmental, social, and governance (or “ESG”) matters. Looking through this conference’s three-day agenda, eight of the forty scheduled sessions are devoted to ESG and related topics. It would not surprise me to hear that IR teams spent at least a similar proportion of their work days focusing on these issues.

You no doubt know that the Commission has increased its attention on ESG matters as well, and the Chair has expressed his intent to propose new disclosure requirements relating to climate change and human capital. [1] I recently shared my belief that the Commission will need to find answers to several questions before it is able to promulgate such rules that would stand the test of time and fit into our historic frameworks. [2] While the complete list is longer, there are three questions I will focus on today:

  1. What precise items of “E,” “S,” and “G” information are investors not getting that are material to making informed investment decisions?
  2. If we were able to identify the information investors need, how would the SEC come up with “E” and “S” disclosure requirements—now, and on an ongoing basis? What expertise do we need?
  3. If the SEC were to incorporate the work of external standard-setters with respect to new ESG disclosure requirements: how would the agency oversee them—in terms of governance, funding, and substantive work product—on an ongoing basis? And what kind of new infrastructure would be required inside the SEC and at the standard-setters themselves?


Commissioner Roisman Suggests Ways to Reduce the Costs of ESG Disclosure

Cydney S. Posner is special counsel at Cooley LLP. This post is based on her Cooley memorandum. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance by Lucian A. Bebchuk and Roberto Tallarita (discussed on the Forum here); For Whom Corporate Leaders Bargain by Lucian A. Bebchuk, Kobi Kastiel, and Roberto Tallarita (discussed on the Forum here); and Restoration: The Role Stakeholder Governance Must Play in Recreating a Fair and Sustainable American Economy—A Reply to Professor Rock by Leo E. Strine, Jr. (discussed on the Forum here).

In remarks [June 3, 2021] before the ESG Board Forum, Putting the Electric Cart before the Horse: Addressing Inevitable Costs of a New ESG Disclosure Regime, SEC Commissioner Elad Roisman weighed in with his views on mandatory prescriptive ESG requirements and the likely associated costs. As he has indicated before, he’s not really keen on the idea, particularly the environmental and social components of potential requirements. As a general matter, while investors want to see comparable standardized environmental data, in his view, standardization of that type of information is really hard to do; some of it “is inherently imprecise, relies on underlying assumptions that continually evolve, and can be reasonably calculated in different ways. And ultimately, unless this information can meaningfully inform an investment decision, it is at best not useful and at worst misleading.” But, if a new regulatory regime requiring ESG disclosure is adopted—and it certainly looks that way— he has some ideas for ways to make it less costly for companies to comply.

In contrast to Commissioner Allison Lee, Roisman believes that more disclosure requirements are practically superfluous because the SEC’s disclosure framework already requires companies to disclose information that is material to investors, and that includes ESG information. More specifically, he noted that the SEC issued guidance in 2010 on the application of existing SEC rules to the material effects of climate (see this PubCo post) and amended Reg S-K to expressly require disclosure about human capital (see this PubCo post). What’s more, he sees no basis for omitting disclosure of any other material risks. So why is more regulation requiring ESG disclosure even necessary?


Vanguard’s Insights on Shareholder Proposals Concerning Diversity, Equity, and Inclusion

John Galloway is global head of investment stewardship at Vanguard, Inc. This post is based on a publication by Vanguard Investment Stewardship. Related research from the Program on Corporate Governance includes Social Responsibility Resolutions by Scott Hirst (discussed on the Forum here).

Risks to shareholder value associated with diversity, equity, and inclusion (DEI) remain a top engagement priority for Vanguard with our funds’ portfolio companies. Increased focus—from companies, regulators, investors, and employees—on racial and ethnic discrimination has heightened scrutiny of public companies’ DEI-related risks and opportunities, as have the COVID-19 pandemic and challenging economic conditions.

Vanguard has long advocated for diversity of experience, personal background, and expertise in the boardroom. In 2020, Vanguard continued to call for enhanced board diversity across dimensions of gender, race, ethnicity, age, and national origin. [1] We reiterated our expectations that boards make progress in their diversity strategy and that where progress falls behind market norms and expectations, the Vanguard funds may vote against company directors. We also outlined our views on diversity beyond the boardroom and our expectations of a board’s role in overseeing DEI risks within the workplace. [2] We illustrated the case for getting it right and the risks of getting it wrong.


Benchmarking of Pay Components in CEO Compensation Design

Yaniv Grinstein is a Professor of Finance at the Arison School of Business, IDC Herzliya; Beni Lauterbach is the Raymond Ackerman Family Chair in Israeli Corporate Governance and a Professor of Finance at the Graduate School of Business Administration, Bar-Ilan University; and Revital Yosef is a Post-Doctoral Fellow at the Graduate School of Business Administration, Bar-Ilan University. This post is based on their recent paper. Related research from the Program on Corporate Governance includes the book Pay without Performance: The Unfulfilled Promise of Executive Compensation, Executive Compensation as an Agency Problem and Paying for Long-Term Performance (discussed on the Forum here), all by Lucian Bebchuk and Jesse Fried.

A central issue in executive compensation is the methodology employed by boards of directors and compensation committees to determine chief executive officer (CEO) pay. In this study, we focus on the practice of compensation benchmarking, in which a given firm compares CEO compensation with the compensation packages of peer CEOs at comparable companies. Previous empirical research has established that peer pay and benchmarking play an important role in determining total CEO compensation.

We extend the benchmarking research by analyzing the benchmarking of the components of CEO pay. Motivated by the description of benchmarking practices in compensation committee reports, we examine the following three questions: Is each pay component benchmarked separately and differently than other pay components? Is the structure of compensation (weight of each pay component in total pay) benchmarked as well? And, is pay component benchmarking a better description of benchmarking practices in US public firms than total pay benchmarking?

We employ two research strategies (and samples) to answer our research questions, and focus primarily on the benchmarking of three major pay components: Salary, equity-based compensation, and non-equity performance pay. First, we read the compensation-committee reports (Form DEF 14A) of S&P 500 firms in fiscal year 2013 and find that approximately 89% of firms explicitly state that they benchmark at least one pay component. Further, about 75% of firms declare that they benchmark all three major pay components. These figures indicate that these firms examine separately the distribution of salary, equity-based compensation, and non-equity-based compensation among peers to determine the level of each pay component to their CEO. We also examine whether companies target CEO compensation structure (weight of each pay component in total CEO compensation), and find that approximately 30% of firms explicitly declare in their proxy statement that they benchmark the compensation mix.


The Biden Administration’s Executive Order on Climate-Related Financial Risks

Natalie L. Reid and David W. Rivkin are partners and Alison M. Hashmall is counsel at Debevoise & Plimpton LLP. This post is based on a Debevoise memorandum by Ms. Reid, Mr. Rivkin, Ms. Hashmall, Gregory J. Lyons, Caroline Novogrod Swett, and Josie Dikkers.

Key takeaways:

  • Last month, President Biden issued an Executive Order (the “Order”) that directs federal agencies to take wide-ranging actions regarding climate-related financial risks.
  • While the Order is directed to agencies across the federal government, there are particular directives that will be especially relevant for the banking industry. In particular, Treasury Secretary Yellen is directed to issue a report that assesses the efforts by FSOC member agencies to integrate consideration of climate-related financial risks into their policies and programs and to recommend actions for mitigating such risk, including through “new or revised regulatory standards.”
  • The Order builds on actions financial regulators are already taking with respect to climate change and may result in greater consideration of various climate-related regulatory initiatives.

Last month, President Biden issued an Executive Order (the “Order”) that directs federal agencies to take wide-ranging actions regarding climate-related financial risks. The Order aims to “advance consistent, clear, intelligible, comparable, and accurate disclosure of climate-related financial risk” across the federal government. It notes that these risks include both physical risks, such as supply chain disruptions from increased extreme weather, and transition risks, which result from a global shift away from carbon-intensive energy sources and industrial processes. The Order states that the failure of financial institutions to appropriately and adequately account for and measure these risks threatens U.S. companies, markets and financial institutions.


How to Accelerate Board Effectiveness Through Insight and Ongoing Education

Steve Klemash is EY Americas Center for Board Matters Leader and Jamie Smith is EY Americas Center for Board Matters Investor Outreach and Corporate Governance Specialist. This post is based on their EY memorandum.

Today’s business environment is continuously resetting the bar for effective board oversight. New business models, impacted by new technologies and consumer behaviors, are emerging, while industry boundaries disappear. At the same time, sustainability risks and social awareness are increasing, driving a reprioritization of stakeholder and corporate values. These developments underscore the need for boards to evolve and learn by incorporating the appropriate external perspectives into their agendas to stay ahead of the curve and position the board as a strategic asset.

How can the board of the future keep pace? To help boards stay agile and relevant, board education practices should adapt to reflect the rapidly evolving external developments and strategy, risks and talent oversight needs. We frequently hear from boards who have a growing interest in tailored education and onboarding sessions for individual directors, committees and boards. We offer the following considerations for boards as they challenge how to strengthen their effectiveness in this area.

Tailor board education to company and individual needs

A robust, future-focused board education plan that is codeveloped by board and committee leaders and informed by the views of management and external advisors is key to advancing board effectiveness. Annually, board leadership in consultation with the CEO and other members of management should consider establishing a formal and customized learning plan for the board, its committees and individual directors. Such learning plans should have qualitative and quantitative goals and objectives. They should flex and adapt to changing market dynamics and regulatory developments, with a focus on meeting the unique learning needs of individual directors, committees and the board. While board and committee sessions should address current and future-focused topics, individual directors may need more baseline learning to bring them up to speed. Individual directors should play a proactive role in communicating their education needs to board leaders.


Competition Laws, Governance, and Firm Value

Ross Levine is the Willis H. Booth Chair in Banking and Finance at University California Berkeley Haas School of Business; Chen Lin is the Stelux Professor in Finance at the University of Hong Kong; and Wensi Xie is Assistant Professor in Finance at the Chinese University of Hong Kong Business School. This post is based on their recent paper.

Policymakers increasingly call for strengthening antitrust laws. For example, the U.S. House Judiciary Committee’s Antitrust Subcommittee concluded a 16-month investigation in October 2020 by stressing the need to bolster antitrust laws, policies, and enforcement. In recent months, authorities in China, the European Union, Japan, and the United Kingdom have also signaled their intent to strengthen antitrust laws. The push for more stringent antitrust laws raises questions about the impact of such reforms on firms. In a recent paper, we provide what we believe is the first analysis of how changes in antitrust laws shape corporate valuations.

Economic theory offers conflicting predictions about the impact of antitrust laws that intensify competition on firm value. The agency view holds that because competition tends to force inefficient firms out of business, intensifying competition spurs firms to reduce inefficiencies. In particular, competition can induce firms to address inefficiencies associated with agency problems that allow managers to shirk, empire-build, tunnel, and engage in other actions that extract private benefits from the firms at the expense of shareholder value. Similarly, competition can generate information about managerial performance that shareholders use to mitigate agency problems. In contrast, other theories highlight how competition can reduce firm value. Intensifying competition tends to reduce market power, squeeze cash flows, and lower profits, putting downward pressure on valuations. Furthermore, by squeezing cash flows, competition lowers firm value by constraining firms from exploring long-run growth opportunities. These conflicting theoretical predictions about the impact of competition laws on firm value help motivate our empirical examination.


General Solicitation and General Advertising

Bradley Berman is counsel and Gonzalo Go and Nicole Cors are associates at Mayer Brown LLP. This post is based on a Mayer Brown memorandum by Mr. Berman, Mr. Go, Ms. Cors, and Anna T. Pinedo.


Rule 502(c) (“Rule 502(c)”) of the Securities Act of 1933, as amended (the “Securities Act”), prohibits an issuer from offering or selling securities by any form of general solicitation or general advertising when conducting certain offerings exempt from registration under the safe harbors provided under Regulation D of the Securities Act. Many have felt that, over the years, this prohibition has impaired capital formation and that it would be more appropriate to regulate actual sales rather than offers. In order to address this, Congress passed the Jumpstart Our Business Startups Act (the “JOBS Act”) directing the Securities and Exchange Commission (the “SEC”) to relax the prohibition against general solicitation and general advertising for certain offerings made in reliance on Rule 506 of the Securities Act (“Rule 506”). The amendments to Rule 506 adopted by the SEC became effective in July 2013. The amendments implemented a bifurcated approach, allowing for private placements to be conducted in reliance on Rule 506(b) without general solicitation and general advertising and for certain exempt offerings to be conducted using general solicitation or general advertising in reliance on Rule 506(c). However, as an additional investor protection measure, an issuer relying on the Rule 506(c) exemption and using general solicitation must limit sales to accredited investors and must take reasonable steps to verify that all purchasers of the securities are accredited investors. [1]


Introducing the “Technergy” ESG Reporting Strategy

Dan Romito is Consulting Partner, ESG Strategy & Integration, at Pickering Energy Partners. This post is based on a Pickering Energy Partners memorandum by Mr. Romito and Addison Holmes. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance by Lucian A. Bebchuk and Roberto Tallarita (discussed on the Forum here); For Whom Corporate Leaders Bargain by Lucian A. Bebchuk, Kobi Kastiel, and Roberto Tallarita (discussed on the Forum here); and Restoration: The Role Stakeholder Governance Must Play in Recreating a Fair and Sustainable American Economy—A Reply to Professor Rock by Leo E. Strine, Jr. (discussed on the Forum here).

Across the existing spectrum of ESG ratings, guidelines, and frameworks, higher quality environmental scores are commonly associated with technology companies while lower relative scores are typically linked to energy companies. This is not necessarily a novel statement, but it does highlight a critical inefficiency. We feel ESG-ratings agencies and, in some cases, reporting frameworks, currently miss the mark in their respective evaluation environmental impact for both sectors. Digitalization, artificial intelligence, and big data are evolutionary trends affecting every sector; however, these trends mean something inherently different for energy. Long-term success for the energy space is contingent upon developing greener technologies and adopting advanced data analytics, yet ratings agencies provide less of an opportunity for energy companies to showcase these explicit talents.

As a result, the narrative conveyed by ESG ratings data fails to outline the longer-term economic reality for most capital-intensive businesses, particularly energy. Empirically speaking, the data indicates environmental impact metrics for the energy and technology sectors are actually converging, but existing ratings data does not reflect this. As paradigm shifts within the global economy materialize, technology and energy are becoming increasingly interlaced. As big data and technological advances continue to represent a greater proportion of the overall global economy, think about the respective “inputs” the technology world will require just to keep the lights on.


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