Is There a Problem With ‘Woke’ Investing?

Among certain circles, woke is a bad word. When it’s paired with investing, it attracts not just negative commentary but also political action. Across the country, states, government agencies, and activists are working to greatly limit or eliminate “woke” investing.

But what exactly are “woke” investments? Are they really even a thing? Why choose to invest in such investments? Should the government get involved in preventing people from investing the way they choose? Are such restrictions designed to protect investors, or are they a way to control options? What is the right answer? Of course, we know there is never one right answer to these questions when it comes to individual preferences.

What Are ‘Woke’ Investments?

Let’s start with the basics by defining the word woke.

Merriam Webster defines woke as “aware of and actively attentive to important societal facts and issues (especially issues of racial and social justice).”

In the context of investing, woke implies a focus on environmental, social, and governance, or ESG, policies of companies or investments. This focus is not welcomed by some politicians and special-interest groups.

Wikipedia says that “members of the political center and right wing [are] using the term woke, often in an ironic way, as an insult for various progressive or leftist movements and ideologies perceived as overzealous, performative, or insincere.”

Michael Hiltzik, business columnist for The Los Angeles Times, writes: “One problem with assessing the rise and fall of wokeness is that the term is vacuous to the point of being meaningless. To some, it signifies acknowledging and accommodating the diversity of American society and culture; to others, it bespeaks a punitive and sanctimonious campaign against white privilege.”

These descriptions show the emotional nuances to the word woke. Is it an awareness and attentiveness to societal issues, or is it a political movement? The answer is in the eye of the beholder.

Choosing ‘Woke’ Investments

Investors who seek out favorable ESG factors do so for either or both of the following reasons:

• They believe companies that consider ESG factors will be better investments.
• They want to support companies that share their values.

According to Morgan Stanley, “50% of investors and nearly 75% of millennial investors made investment changes—or plan to—in response to social justice movements.”

In Schroders’ Global Investor Study 2022, “More than two thirds (68%) of people who class themselves as having ‘expert/advanced’ investment knowledge believe sustainable investment is the only way to ensure profitability in the long term.” Additionally, these investors believe that investment choices can affect sustainability concerns.

The “righteousness” of ESG can be a motivating or demotivating consideration based on the investor’s individual outlook, but from a purely financial standpoint, ESG, when actively applied, should minimize certain financially material risks. In other words, ESG-focused companies should have less exposure to risks such as discrimination lawsuits, losses from environmental disasters, and repercussions from illegal activity.

Statistics on ESG investment performance versus the general market tend to vary based on the time period. In 2021, ESG strategies outperformed the broad market. In 2022, ESG investments lagged.

Yet, Alyssa Stankiewicz, associate director at Morningstar Research, says that ESG-focused funds delivered better returns than their conventional peers over the trailing three-year and five-year periods. “You never really know the merit of an investment strategy until you see it, so to speak, get punched in the face by market headwinds. And I think 2022 was that punch in the face for some sustainable funds. So, in light of that, I think it was actually encouraging to see that they performed in line with what you would expect, and it didn’t erase that intermediate-term outperformance,” Stankiewicz says.

Treasury Secretary Janet Yellen believes that ESG investing is vital to our long-term economic stability. According to Yellen, “As climate change intensifies, natural disasters and warming temperatures can lead to declines in asset values that could cascade through the financial system. And a delayed and disorderly transition to a net-zero economy can lead to shocks to the financial system as well.”

Attempts to Limit ‘Woke’ Investing

In a free society, individual investors should have the right to invest in what they want. In an equitable society, it is the government’s job to protect investors. For example, in the United States, the securities brokers and investment advisors are regulated, pension plan investments must be managed prudently, and private placement investing is only allowed for accredited investors. But if the government wants to limit an investor’s ability to purchase ESG investments, does that go beyond protection and more toward forcing certain political ideologies?

At the federal level, the government can directly have an impact on retirement plan investment choices. The Employee Retirement Income Security Act of 1974, or Erisa—the law that regulates retirement plans—requires that plan fiduciaries invest prudently and act solely in the interest of the plan’s participants and beneficiaries. A recent Latham & Watkins Client Alert Commentary noted that the Department of Labor “has maintained a long-standing position that Erisa fiduciaries may not sacrifice investment returns or assume greater investment risks as a means of promoting collateral social policy goals.”

Clearly, the requirements to invest prudently and in the participants’ best interests are designed to protect pension beneficiaries.

On Nov. 13, 2020, the DOL, acting under the previous administration, published a final rule to require plan fiduciaries to select investments based solely on consideration of “pecuniary factors”—meaning ESG factors were not allowed to be considered. Was protection of beneficiaries the justification for this rule? If considering ESG factors would significantly produce lower returns on behalf of plan beneficiaries, then the DOL would be properly acting within its rightful purview. But, as above, there is no definitive evidence that this is the case.

In 2021, the DOL announced that it would not enforce the rules disallowing consideration of ESG factors in retirement plan investments. And, effective Feb. 1, 2023, the DOL’s Final Rule clarifies that ESG factors may be relevant to the risk/return analysis of potential investments.

On Feb. 27, the Congressional Sustainable Investment Caucus released a statement saying, in part, “Retirement plan fiduciaries should be free to consider climate change and other ESG factors without regulatory barriers or the threat of litigation. The rule from the Department of Labor does not require fiduciaries to consider ESG factors, it merely allows them to do so if it is in the best interest of their plan participants.”

In response, on Feb. 28, Congress issued H.J. Resolution 30, disapproving the new Final Rule. Supporting this resolution, U.S. Rep. Michael C. Burgess, R-Texas, vice chairman of the House Rules Committee, said, “I would like to commend … H.J. Res. 30 [without which] pensioners and retirees would be defenseless against the designs and machinations of a loud but vocal minority planning to conscript the retirement savings of retirees and American workers to pursue an investment agenda that is not founded on a fiduciary responsibility to maximize a return on investment.”

On March 1, the Senate passed the House resolution, and the bill was sent to the President Biden, who vetoed it.

Federal-level limitations on ESG investing are supplemented by state legislation, primarily in red states. In “Navigating Fiduciary Duties Amidst the Rise of Anti-ESG Rulemaking,” Douglas Baumstein, et al. say, “While ESG-focused investing has proliferated, the efforts against this movement in Republican-dominated states have been significant. In the past year, at least twenty-three states have proposed or adopted some form of state legislation or regulation aimed at preventing state pension funds or agencies from doing business with investors or companies that consider ESG criteria. These ‘boycott’ bills often invoke the concern that consideration of ESG factors is politically or socially motivated and taken at the expense of shareholder returns.”

On the other hand, the authors note that “at least nineteen states—particularly those where Democrats are politically dominant—have embraced the new ESG trend in investing by passing bills through state legislatures or instituting rules and regulations that encourage or even require the consideration of ESG factors, particularly concerning the investment decisions by public pension funds.”

Responses to Attempts to Limit ‘Woke’ Investing

Baumstein argues that laws requiring state pension funds focus solely on “pecuniary factors” and disregard “social, political, or ideological interests” imply that consideration of ESG factors will necessarily “sacrifice investment return in favor of social interests.”

Steven Rothstein, managing director, Ceres Accelerator for Sustainable Capital Markets, says, “Telling investors to not think about climate change is like telling them they shouldn’t be thinking about inflation.”

Perhaps the most precise rebuttal to these limitations is Biden’s statement when he vetoed the bill reversing the Final Rule on March 20. “I just signed this veto because the legislation passed by the Congress would put at risk the retirement savings of individuals across the country. ... They couldn’t take into consideration investments that would be impacted by climate, impacted by overpaying executives, and that’s why I decided to veto it.”

With some states limiting ESG investing and some states encouraging—or even requiring—consideration of ESG factors, pension administrators investing for multistate entities have a real dilemma. These opposing rules could mean bifurcating investment styles based on each employee’s state of residence.

How Do We Move Forward?

Regulations and investment decisions should be based on knowledge, not hype. Individual investors should be able to invest as they choose—as long as those investments are not designed to defraud them. Pension funds must make investment decisions in the best interests of beneficiaries. These “best interest” standards are properly regulated by Erisa (and Congress), and these regulations should be based on facts, not political motivation.

Brock Johnson, president of Morningstar’s Global Retirement and Workplace Solutions, says: “Every employer will need to evaluate whether [ESG] makes sense for their employees. If ESG risk can have a material impact on a fund’s performance, then it makes sense that it be considered as part of the overall investment selection process.”

Unfortunately, the simple consideration of ESG risks is being used as a political scapegoat. A recent example is the collapse of Silicon Valley Bank. The collapse revealed a failure of regulation. SVB primarily invested bank funds in long-term Treasury debt, betting on stable interest rates. When depositors began to initiate higher cash withdrawals, SVB was forced to sell the investments at a loss. This cycle continued until the bank failed.

Instead of focusing on SVB’s poor investment strategy and why it was allowed to implement it, some Republicans blamed “woke investing.” U.S. Rep. James Comer, R-Ky., said, “We see now coming out they were one of the most woke banks in their quest for the [environmental, social, and governance]-type policy and investing.” Florida Gov. Ron DeSantis said, “This bank, they’re so concerned with [diversity, equity, and inclusion] and politics and all kinds of stuff. I think that really diverted from them focusing on their core mission.”

But the bank didn’t fail because it was concerned with social justice. It failed because it made a bad bet on interest rates.

Rather than attacking the consideration of ESG factors as “woke investing,” legislators and regulators should focus on giving investors the ability to properly assess and protect against risks. This means:

• Discourage “greenwashing” by creating standards by which companies and funds are allowed to label themselves as ESG.
• Ensure that pension administrators document due diligence in investment decisions.
• Properly monitor illegal corporate activities.

Choice Should Be Yours

If your values are of primary importance when allocating investment dollars, by all means, either choose or avoid ESG-focused stocks and funds based on your personal preferences. If maximizing returns and minimizing risk are your goals, then ESG factors are worth considering.