World Views | The world’s largest pension fund has cooled on ESG. Should you?

Shuli Ren, Bloomberg

If a pioneer investor in ESG is getting cold feet, should you?
In July 2017, Japan’s $1.6 trillion Government Pension Investment Fund — the world’s largest — blazed a trail by putting 1 trillion yen ($9.1 billion) into three indices that track Japanese stocks that put emphasis on environmental, social and corporate governance issues. GPIF then plowed 1.2 trillion yen into two carbon-efficient indices in 2018, and another 1.3 trillion yen into two ESG foreign equity indices last December.
But top officials of the pension fund have been talking up fiduciary duty lately. GPIF “can’t sacrifice returns for the sake of buying environmental names or ESG names,” a senior director at the fund’s investment strategy department told Bloomberg News in April.
At issue is poor performance. For instance, one of GPIF’s earliest ESG picks was a thematic social index, which invests in domestic companies that hire and promote women. The MSCI Japan Empowering Women Index, the so-called Win index, has fared poorly against the benchmark Topix Index. Performance is all-important to GPIF: the fund is required to pursue a real investment return of 1.7% to support an aging Japan.
So what does this mean for the future of ESG investing? Since Joe Biden won the election in early November, passively-managed ESG funds saw a sharp uptick in investor demand. But will that strong inflow last? Could GPIF’s shifting attitude foretell a cooling of this global trend?
First, flow does not guarantee returns. Just because a passive ETF [exchange-traded fund] has received billions of dollars of buying does not mean it will outperform, as GPIF has learned.
If anything, flow tends to follow performance, leaving funds susceptible to large withdrawals.
Second, ESG is too broad a category. Funds that focus on environmental issues can have very different return profiles from social or governance thematic funds. In Japan, despite former Prime Minister Shinzo Abe’s Womenomics rhetoric, gender diversity simply was not a winning strategy. Of Topix 500 companies, those with no women on the company board generated, on a five-year basis, an 8% return on invested capital, a good 1.3 percentage points higher than corporations with women board members, data compiled by CLSA analyst Nicholas Smith show. This doesn’t mean women aren’t competent managers: Japan’s male-dominant corporate culture may have placed women with no relevant experience into senior positions merely for show and PR. Nonetheless, the inferior return on capital of gender-diverse companies explains why the Win Index was a losing proposition.
On the other hand, passive funds that claim high carbon efficiency can fare very well. The S&P Global ex-Japan LargeMidCap Carbon Efficient Index, which the GPIF started tracking since 2018, is by far the best performer of the last year. A look at its holdings shows why: Big tech FAANG stocks and Tesla Inc. are among the top constituents, and the U.S. market — the world’s most resilient — accounts for 63% of the fund.
That begs the question: If carbon efficiency is simply tech, do we really need to invest in an ESG fund? We could have bought into the cheaper and more liquid Invesco QQQ Trust, which tracks Nasdaq 100, and still feel pretty good about saving the planet. The two indices are highly correlated.
No doubt, with the European Union and Biden administration pushing fiscal stimulus money into clean energy and climate technology, ESG investing will remain a hot topic. But if the world’s largest pension fund seems to have become more circumspect, shouldn’t you? From the perspective of pure returns, passive ESG investing can still be fruitful, but one has to be nimble and practical, able to switch quickly from one thematic fund to another — or out of ESG funds altogether. Dogma won’t work. Shuli Ren, MDT/Bloomberg
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