Fiduciary Duty & ESG: Why Materiality Matters

U.S. Department of Labor ‘Guidance’ and Materiality

In October 2015, the U.S. Department of Labor (DOL) issued a hugely important ‘guidance’ concerning ESG and fiduciary duty, with the slightly confusing title, “Interpretive Bulletin Relating to the Fiduciary Standard under ERISA in Considering Economically Targeted Investments.”[1] The somewhat misleading title focuses on economically targeted investments (ETI), but what is made very clear in the body of the interpretive bulletin the actual and broader focus is on environmental, social and governance factors (ESG). As the DOL itself clarified the title: “Various terms have been used to describe this [ETIs] and related investment behaviors, such as socially responsible investing, sustainable and responsible investing, environmental, social and governance (ESG) investing, impact investing, and economically targeted investing (ETI). The terms do not have a uniform meaning and the terminology is evolving.”

Core to the significance of the DOL guidance is the statement that, “The guidance also acknowledges that environmental, social, and governance factors may have direct relationship to the economic and financial value of an investment. When they do…[they] are proper components of the fiduciary’s analysis of the economic and financial merits of competing investment choices.” (Emphasis mine) There are three critical elements here:

  1. The recognition that of what increasingly large numbers of markets participants are doing re: ESG and performance (risk/opportunity);

  2. The recognition of the potential materiality of ESG factors, where relevant, which are by definition economic and financial;[2] and,

  3. The recognition that going forward this logic obligates fiduciaries to conduct due diligence to determine materially relevant E and S and G factors (if any) for all investments.

As my prior blogs (here, here and here) have discussed the U.S. Supreme Court’s definition of the ‘reasonable investor’ is that she is, for example, rational, focused on making a profit from her investments, and is knowledgeable about the risk of investing. What has changed and is still in process of changing are the components of these three characteristics, what the SEC based on the U.S. Supreme Court rulings call the ‘total mix of information’.[3] For example, rational is tempered by the widespread recognition that irrationality can play a role, and at critical moments, perhaps a crucial role in market dynamics. In terms being profit oriented, there is increased focus on the time scale of such goal-oriented actions. Thus, the critique of the perceived short-termism of markets is critical in defining the temporal parameters for profitable investments. And finally regarding risk and opportunity, there is now an increasingly widespread perception that the E and S and G factors may be material. Additionally there has been greater appreciation of the systemic risk elements in, for example, climate change as part of E with major S ramifications, and indeed, in the financial markets themselves beyond the ESG nomenclature.[4] In short, what the ‘reasonable investor’ finds reasonably material has and continues to undergo profound change and is evolving.[5] In many respects the DOL is playing catch-up to leading sectors of markets in its (somewhat belated) recognition of these developments. Yet such recognition does not diminish the significance the DOL bulletin for fiduciaries.

Fiduciaries, Investment Portfolios and Modern Portfolio Theory

In an article I published in 2011, co-authored with Keith Johnson and Ed Waitzer, we suggested that there was a move toward ‘reclaiming fiduciary duty balance’, that indeed fiduciary duty was at a 21st century inflection point.[6] A number of long-term developments underlie such a change. Among the most important we suggested are:

  • The domination of asset markets by (very large) institutional investors;

  • The related growth of a complex (and often compromised by conflict of interests) investment chain of intermediaries between investors/ beneficiaries at one end, and actual investments at the other end;

  • Financial market fragility, disruption and the threat of systemic shocks.

Along with other less transformative factors the above three developments call into question the late 20th century understanding of fiduciary obligation in some important respects as well as parallel modern portfolio theory’s (MPT) understandings of equity market dynamics, portfolio construction and risk mitigation. In fact these two developments have been not only parallel, but also interactive. That’s because interpretations of what constituted fiduciary duty and best and/or acceptable practice (on the part of institutional investors) was based on the growing acceptance and practical significance of MPT itself. The landmark passage of ERISA (the Employee Retirement and Income Security Act of 1974) set the stage for the transformation of both public and private pension fund investment strategies, enlarging what was considered prudent (under the so-called ‘prudent ‘man’ (read: person) standard’ upon which U.S. fiduciary law is based. Most important in this regard was legitimization for pension funds of moving into equity as compared to ‘safe’ bond investment, which had prior to the mid-1970’s dominated portfolios. This was exactly in line with the acceptance and understandings of MPT perspectives. MPT’s impact in this regard cannot be underestimated. ERISA did not explicitly mention MPT, but its effect was not only to legitimate MPT’s adoption but also to make it a de facto fiduciary standard focused on the duty of prudence.[7]

Most important regarding market dynamics has been the conceptual and practical dominance of MPT in portfolio construction and management, and on the related understandings of market workings and dynamics. Among the key practical implication of MPT is not just the need not for portfolio diversification but also how one measures performance in relation risk: on a holistic portfolio basis. Core to this development is MPT’s central distinction between idiosyncratic (individual security) and systemic risk (entire market, ‘beta’) risk, the former manageable, the later pretty much entirely exogenous and not manageable.

Yet the very success of MPT in one form or another as the basis for the vast majority of institutional portfolio construction and management has had a serious (some might argue fatal) unintended consequence (as in, ‘be careful what you wish for’). What could and did work when markets were not dominated by large institutions came to work in an unintended way as institutions (individually) when smaller and not dominant were price takers. These institutional actors became transformed into (often unconscious) price makers. Such unconscious collective action made institutions operating as en effective group become what is known as a ‘super portfolio’. This happens when a large number, often the majority of large institutions, move in one direction (buying or selling) more or less at the same time, having the effect of moving markets as if these institutions were one giant portfolio.[8] In short, herding (which has a number of other factors driving it as well) is in part driven by the widespread adoption of MPT. The partial dissolution of the once clear division between idiosyncratic and systemic risk occurs because systemic risk can be (but certainly not always is) created by or contributes to attempts minimize portfolio idiosyncratic risk. This is strongly the case when the super portfolio effect occurs.

Why is this important to the DOL’s recognition of ESG factors as potentially economically and financially significant? In part because some E and S issues in particular have systemic impacts and implications. They cannot be mitigated or diversified away within a portfolio (that is, they are neither idiosyncratically nor exogenously systemic), but rather inhere within the portfolio itself and/or within a super-portfolio dynamic. Whether the DOL is aware of this is certainly not clear from the Guidance, but that is one clear implication.[9] If this argument is correct, it opens a host of possible activities which I believe can be defended as necessary to executing institutional fiduciary duty, especially the duty of prudence.

While the DOL’s Guidance does not alter what the ‘reasonable investor’ standard is, it clearly opens the door to, and comes close to stating that fiduciary duty demands, an expansion of the ‘total mix of fact’ that the reasonable investor should or must conduct due diligence upon. Indeed, these reflect global developments. For example, the U.K’s stewardship guidance, the French CSR/carbon mandated disclosure laws and a few years ago, South Africa’s King initiatives all reflect fiduciary or fiduciary-like due diligence. In a similar vein, for example, CalSTRS notes “…consideration of environment, social and governance issues…are consistent with the Board’s fiduciary duties.”[10]

Emerging Fiduciary Standards and Challenges

There are important emerging ESG related issues. While ‘short-termism’ has long discussed as a meta-investment problem, there is increased push back against quarterly (and even less, e.g nano-second flash trading) short-term focus. Recently, for example, Larry Fink, BlackRock’s CEO, argued for substituting what he called integrated strategic guidance in place of the current quarterly earning guidance. He wrote to corporate CEO’s: “We asking that every CEO lay out for shareholder each year a strategic framework for long-term value creation…CEO’s should explicitly affirm that their boards have reviewed those plans.” Specifically, year-to-year (and quarter to quarter) progress should be measured against strategic plans, not deviation from EPS [earnings per share] targets or analysts’ estimates.[11] Long(er)-term focus includes, indeed centrally includes, material factors, including E and S and G developments as relevant. Add to those systemic risk factors, this package become part and parcel of emerging fiduciary duties and obligations. Thus, they are central to portfolio construction and monitoring.

We have been discussing the duty of prudence elements in fiduciary duty. Let’s consider briefly the duty of loyalty, and specifically a sometimes-overlooked element of it, the duty of impartiality. Impartiality stipulates that a fiduciary cannot favor one cohort or group of beneficiaries or investors at the expense of another. For example, older individuals can’t be favored at the expense of younger ones; retirees at the expense of new members or new investors. For example, climate change which will impact those in their 20’s far more than those currently in their 70’s. Climate risk need therefore be addressed in terms of the time horizon of the investment entity, in this case over half a century. For the vast majority of institutional investors (managing retirement monies in various forms) this means due diligence about climate risk should be a fiduciary imperative. In the U.S. the CFA Institute recognizes this, has developed curriculum for CFA candidates, and mandates knowledge about ESG.[12]

Another example of emerging fiduciary challenge is concern about peer based benchmarking: doing what other professional investors in ‘like circumstances would do.’ What has been called the ‘lemming standard’ is a direct result of the very success of MPT itself, as discussed above. Benchmarking portfolio performance, and portfolio managers’ performance individually, has had the unintended and perverse effect of driving portfolios to mirror each other (although there are other reasons this has happened as well). Benchmarking contributes to the MPT paradox: managing idiosyncratic risk when acted upon in similar ways by large number of market actors (super portfolios) in order minimize under performing a benchmark can unintentionally increase systemic risk.

How is this related to emerging fiduciary challenges? Exactly because it vitiates the original meaning of the duty of prudence. ‘Prudence’ (as in the ‘duty of…’) is from the Latin ‘prudentia’: meaning an act of foresight. The specific content of foresight cannot, of course, be stated in the abstract, but rarely has it meant calculating divergence from a benchmark, which is fundamentally itself calculated or constructed based on what the crowd does or did. It is entirely relative and retrospective. In this sense, it means, as in the Fink quote above, focusing (or re-focusing) on value creation and associated risk and opportunities. Value creation is an absolute standard (for which metrics can be developed as key performance indicators), while benchmarked returns are relative (and have become increasingly short term as well.)

As a side note (and one that could and perhaps will be developed in a future blog) this also means that especially for large highly diversified institutional asset owners and investors (such as BlackRock, TIAA-CREF, CalPERS, Vanguard) a focus on creating a better beta, not a search for alpha. A better beta means fundamentally the market as a whole focused on longer-term value creation, not on finding (short term) alpha. Alpha seeking may work as a core strategy in some instances for boutique investors, but for large ones (the ones that dominant markets) alpha (when successful) contributes at most 10% of returns.[13]

Taken together the point of fiduciary duty, and specifically duty that incorporates ESG factors, means focusing on what Peter Drucker decades ago characterized as ‘maximizing the wealth producing capacity of the enterprise.’[14]

In previous writings I’ve characterized the current development of U.S. (and many other national and regional) capitalisms as ‘fiduciary capitalism.’ By this I simply mean that asset markets (not just equity and bond markets) come to be dominated by large institutional investors, the majority of which are fiduciaries, obligated to their beneficiaries (in the case of pension funds) or investors (in the case of, for example, mutual funds). This is historically new. There are, therefore, some important fiduciary challenges of fiduciary capitalism. Among some of the most important are:

  • The imposition of fiduciary liability (and duty) throughout the investment supply and service chain;

  • The use of conflict of interest screening in the selection of service providers;

  • Full transparency if there are conflicts of interest or perception of such conflicts, both along the supply and service chain, with within asset owner or manager organizations themselves;

  • The alignment of service provider interest and fund participants and investors (and not just, in ERISA language, ‘the plan’);

  • The move to long-term, strategic foci with the duty of impartiality in mind;

  • The implementation (and specification) of the do no harm principle.

In conclusion, there are some recent interesting harbingers of what may hopefully be to come. For example, in the last few months Morningstar’s fund ratings will be rated for ESG standards based on Sustainalytics ratings. In parallel MSCI will separately rate all U.S. mutual funds using its standards. These are signs of progress and possibilities.

But they also raise some questions and perhaps problems. For example, what is the meaning of two companies rating about 22,000 mutual funds? Their methods are proprietary, they are black boxes. Could there be unintended herding effects? Are their fiduciary implications of relying on only two raters? Will others enter? How are investors to interpret what may well be different ratings, perhaps radically different ratings for a particular fund? How are these efforts related to SASB’s (and other organization in various different jurisdictions) efforts to standardize ESG materiality disclosure for all publicly listed companies? What would be the implications if SASB and similar efforts become either de jure or de facto standards, effectively making public good from what are now various proprietary standards?

These are all challenges and possibilities; these are ‘good problems’ going forward.


[2] SEC Comissioner Kara M Stein makes a similar point: “What investors want changes. Materiality evolves. It changes as society changes, and it also changes with the availability of new and better data. To achieve effective disclosure, we must understand what is important to today’s investors.”

[3], p. 37.

[4] See for example The Investment Integration Project ( and, the Financial Stability Board (, the latter focusing not only financial but climate risk as well (

[5] The SEC recently issued a ‘concept release’ related to regulation S-K (disclosure) focused to a great extent on how materiality changing.

[6] ‘Reclaiming Fiduciary Duty Balance, 4/2, Fall 2011, Rotman International Journal of Pension Management.

[7] See, 29 U.S.C. §1104 (a)(1)(C), re: the diversification rule regarding minimizing portfolio risk as a mandatory requirement, unless it would increase risk. The core notion of diversification is based on MPT’s understanding of mitigating idiosyncratic risk.

[8] See, Mehdi Beyhaghi and James Hawley, ‘Modern Portfolio theory and risk management: assumptions and unintended consequence’, Journal of Sustainable Investment and Finance (3:1) 2013. For a quick summary (and criticism) of MPT, see:

[9] For a full and insightful discussion of MPT and related financial theories and practices, see Donald Mackenzie, An Engine, Not a Camera, How Financial Models Shape Markets, MIT Press, 2006.


[11], February 2016.


[13] Aaron Bernstein and James P. Hawley, ‘Is the search for excessive alpha a breach of fiduciary duty?’, in The Cambridge Handbook of Institutional Investment and Fiduciary Duty (Cambridge University Press, 2014), pp.171-180; and Roger Ibbotson, ‘The importance of asset allocation, Financial Analysts Journal, 2010, no. 66)

[14] Peter Drucker, Managing for the Future, p. 196, New York (Routledge), 2011 (originally published 1993).

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