SEC Proposals for ESG Ignore 80 Years of Financial Science

The US Securities and Exchange Commission is concerned that retail investors who want their investment managers to factor environmental, social and governance considerations into investment decisions are being duped by “greenwashing” — token actions with no material effects —and marketing materials that overstate what the managers are actually doing. This is a valid concern, but the SEC’s solutions are straight out of the New Deal, top-down playbook from the 1930s.

The first change proposed by the SEC is to apply the “80% rule” to funds with names that suggest a focus on ESG focus, meaning 80% of the asset value of the fund must be in assets described by the name. But for the last 70 years, Modern Portfolio Theory has held sway in finance. You don’t evaluate investment securities one at a time; you look at the statistical properties of the portfolio as a whole.

This idea is clearer with international stocks funds than with ESG. In the late 1980s, foreign stocks were strongly outperforming US stocks, so foreign stock and international stock mutual funds became popular. The easiest way to make a stock fund international was to buy large-cap, multinational companies that happened to be headquartered in Europe, Japan or elsewhere. But these companies were influenced by the same economic fundamentals as large capitalization US multinational companies, so the resulting funds had high correlations to the S&P 500 Index, often higher than most US equity funds.

What investors wanted wasn’t a high proportion of fund assets in companies domiciled outside the US, they wanted low correlation to the S&P 500 for diversification, and high correlation to foreign stock markets because those were doing well. That was harder to deliver because it meant going into foreign stock markets, analyzing companies that used unfamiliar accounting principles and whose documents were not always available in English, working with foreign banks and dealers, understanding differences in legal jurisdictions, etc. When you did that, you found that there were US-domiciled companies with strong foreign stock exposure, and foreign-domiciled companies with little foreign stock exposure. The optimal portfolio balancing S&P 500 correlation, foreign stock correlation and expected return might have more than 20% US-domiciled stocks.