Anyone participating in the Federal government’s Thrift Savings Plan (TSP) is familiar with the C Fund. The fund includes the stocks of large and medium-sized U.S. companies and is designed to match the performance of the Standard & Poor’s 500 (S&P 500) Index.
Over the past 10 years it has produced a compound annual return of more than 13%, although it did post a loss of 4.41% for 2018.
Now, S&P Dow Jones Indices, the organization that provides the S&P 500 Index, has launched the S&P 500® ESG Index, which they describe as:
“An innovative index that is aligned with Environmental, Social and Governance (ESG) selection guidelines and designed to closely replicate the risk and return profile of its most iconic benchmark.”
According to Wikipedia, the S&P Dow Jones Indices has over 130,000 indexes, but the creation of this new S&P 500 ESG Index coincides with a letter sent to the Government Accountability Office (GAO) by Senators Jeff Merkley (D-OR) and Maggie Hassan (D-NH) requesting that GAO study and report back on:
- What is known about the exposure of TSP’s investment portfolio to risks from climate change?
- What steps, if any, have TSP and the Federal Retirement Thrift Investment Board taken to address risks from climate change?
- What have defined contribution plans in other nations with investment options similar to TSP (such as those in the U.K. and Hong Kong) done to address investment risks from climate change? What have they done to communicate this information to participants?
- How have TSP’s fossil fuel holdings performed over the past decade? How would TSP’s overall financial performance [have] differed without fossil fuels?
Adopting a C Fund ESG by the Federal Retirement Thrift Investment Board (FRTIB) would mitigate these concerns.
What is ESG?
In general, ESG refers to using a set of Environmental, Social and Governance (ESG) factors as screens to determine the inclusion or exclusion of a company from an investment index.
Before the current ESG trend, investors were mainly focused primarily on financial returns – how much money will I gain by buying stock in this company?
But ESG adds an additional layer to this by also considering the sustainability of the business investment as well as the ethics surrounding that business.
Proponents of ESG argue that considering ESG factors actually produce superior investment returns and that ESG-focused companies outperform companies with lower standards of conduct.
An early example was investment in tobacco companies. While manufacturers of cigarettes posted large profits, as the link between smoking and cancer became more widely recognized, some investors became concerned that the immediate profits hide longer-term investment dangers.
Another example was the move to demand that companies disinvest from companies doing business in South Africa when that country was led by an apartheid government.
In both cases, advocates for disinvestment argued that the activities of the target companies were incompatible with the long-range sustainability of their businesses.
Over time, the concept of ESG has expanded to include a range of criteria, and there is no one definition of what constitutes an ESG-accepted investment, but many current ESG investments tend to be concerned about
- Climate Change
- Fossil Fuels
- Nuclear Energy
- Human Rights
These concerns tie in with the Senators’ letter to GAO, and so introducing an ESG-focused C fund would meet many of their concerns over the financial risk facing retirement plans that ignore companies’ commitments to climate change.
Understanding the S&P 500 ESG Index
According to an explanation provided by S&P, the S&P 500 ESG Index excludes tobacco, controversial weapons, and companies not in compliance with the UN Global Compact (UNGC).
The Ten Principles of the United Nations Global Compact are derived from: the Universal Declaration of Human Rights, the International Labor Organization’s Declaration on Fundamental Principles and Rights at Work, the Rio Declaration on Environment and Development, and the United Nations Convention Against Corruption. The principles include concerns for:
Principle 1: Businesses should support and respect the protection of internationally proclaimed human rights; and
Principle 2: make sure that they are not complicit in human rights abuses.
Principle 3: Businesses should uphold the freedom of association and the effective recognition of the right to collective bargaining;
Principle 4: the elimination of all forms of forced and compulsory labor;
Principle 5: the effective abolition of child labor; and
Principle 6: the elimination of discrimination in respect of employment and occupation.
Principle 7: Businesses should support a precautionary approach to environmental challenges;
Principle 8: undertake initiatives to promote greater environmental responsibility; and
Principle 9: encourage the development and diffusion of environmentally friendly technologies.
Principle 10: Businesses should work against corruption in all its forms, including extortion and bribery.
The new S&P 500 ESG Index eliminates companies that:
- Produce tobacco, have tobacco sales accounting for greater than 10% of their revenue, derive more than 10% of their revenue from tobacco-related products and services, or hold more than a 25% stake in a company involved in these activities;
- Are involved in controversial weapons, including cluster weapons, landmines, biological or chemical weapons, depleted uranium weapons, white phosphorus weapons, or nuclear weapons, or hold more than a 25% stake in a company involved in these activities;
- Have a UNGC score that is in the bottom 5% of scores in the eligible universe; or
- Have an S&P DJI ESG Score that is in the bottom 25% of scores within their Global Industrial Classification Standard (GICS) industry group in the S&P Global Large-MidCap and S&P Global 1200.
Overall, 154 constituents of the S&P 500 have been excluded from the S&P 500 ESG Index, totaling 23.43% of the S&P 500 market capitalization as of December 2018. Among the companies eliminated from the S&P 500 ESG Index are Boeing, Lockheed Martin, Netflix, and Home Depot. Once a company is removed from the index, it is not eligible again for a full calendar year.
S&P has found that despite excluding more than 30% of constituents based on the various eligibility criteria, the ESG Index closely tracks the S&P 500 Index. Realized tracking errors for the one-, three-, and five-year periods were consistently within 1%, and the index volatility was nearly identical to the S&P 500 over those same periods.
Advantages to TSP
By creating an index that attempts to equal the performance of the S&P 500 ESG Index, TSP can
- Satisfy Congress that it takes ESG seriously
- Use a known benchmark to measure performance of its fund
- Meet the needs of younger Federal employees who may be concerned about the environmental and ethical impact of their investments
This change does not come without costs. Each additional fund adds to TSP’s administrative costs, and there is a chance that the ESG C Fund may underperform its other funds, but given the mood in Congress, especially in the House of Representatives, the eventual creation of an ESG fund may be inevitable, especially if the Democrats win the White House in 2020.