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If you were worried about censorship on social media, you can breathe a sigh of relief. A non-fan of environmental, social, and governance (ESG) investing recently expressed his opinion in a two-word tweet, one of which was the four-letter kind. In short, both disdain for political correctness and obscenity qualify as protected free speech on Twitter.

It is certainly understandable that market participants differ on the question of adopting an ESG regimen. Less obvious is why anyone should express hostility toward those who would rather not profit from certain activities. Examples include production of anti-personnel mines, nuclear weapons, cluster weapons, biological and chemical weapons, depleted uranium, and white phosphorus munitions.  To some investors, the abstainers might appear pathetically misguided, but what harm are they doing?

I recently studied ESG investing in the specific context of high yield bonds. My analysis found that avoiding issuers with poor ESG ratings from Sustainalytics conferred no statistically significant advantage or disadvantage in average return over time.

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At first blush, the ESG-based high yield indexes overseen by ICE Indices, LLC did provide better protection in down markets than the standard high yield index. Upon closer examination, though, that result proved illusory. Casting out issues with poor ESG scores disproportionately eliminated the bonds with the lowest credit ratings. The process also reduced concentration in the highly volatile Energy sector. Investors who adjusted their allocations in similar fashion would have done equally well in downturns, whether they owned ESG good citizens or bad citizens.  

Other researchers have found similar results in equities. If an ESG discipline neither helps nor hinders performance, there is no good reason for investors who prefer a different approach to deride it in barnyard language. At worst, ESG investors’ shunning of certain stocks will create underpricing that other traders can exploit.

A Regulatory Controversy

Despite all the preceding points, ESG investing currently faces a potential setback at the hands of the federal government. In June, the U.S. Department of Labor (DOL) proposed new regulations that would require retirement plan administrators to select investments solely on financial considerations. The proposed rules would prohibit pension plans from subordinating return or increasing risk in pursuit of non-financial objectives.  

Several major asset managers quickly objected, arguing that a failure to take into account risks such as climate change and excessive executive compensation could actually harm investors. That line of reasoning may prove effective, but there is another approach that could helpfully complement it.  An argument for ESG can be made on grounds of religious freedom.

Should the government prohibit pension plan sponsors from accommodating individuals whose faith conflicts with investing in alcohol, tobacco, or pornography? Such a ban seems hard to reconcile philosophically with the current administration’s support of religiously affiliated healthcare providers that object to offering contraceptive services.

Establishing the legitimacy of retirement plans that honor participants’ religious principles would be the beachhead of this proposed strategy. If pension regulators conclude that they must permit administrators to consider faith-related issues, what about matters of conscience? Consider another public policy sphere, the compulsory military service that existed from 1940 to 1973 in the United States. Exemptions on grounds of conscientious objection were granted on the basis of deeply held moral or ethical beliefs, as well as formal religious convictions.

ESG Has Obtained a Foothold

Regulatory issues are not the only factor affecting the growth of funds that avoid certain securities based on scores assigned by ESG raters. Practitioners currently express dissatisfaction with the ratings’ consistency. Within many investment organizations, however, integration of ESG considerations with traditional security analysis is now firmly established as a means of identifying long-term risks. As a consequence, flinging curse words will not make ESG disappear from the investment landscape.