This article originally appeared in Barron’s on May 28, 2020.
In a relatively short time, BlackRock has become the largest asset manager in the world. The firm built its impressive franchise as a low-fee, efficient provider of index portfolios. Now, however, Larry Fink, the mortgage-bond trader who founded the firm in 1988 and has been CEO ever since, wants to take BlackRock in a different direction. Why? And what does the shift mean for clients, especially pension funds?
BlackRock held its annual shareholders’ meeting last week and emphasized the new role of sustainability standards in its letters to clients and CEOs. On March 31, 2020, even after a rough month in the markets caused by Covid-19, BlackRock was still managing nearly $6.5 trillion in stocks, bonds, and cash—an almost 15-fold increase over 15 years. The firm’s index portfolios, including its iShares exchange-traded funds, comprise 70% of its long-term holdings. The firm is the second- or third-largest owner of stock in Microsoft, Apple, Amazon, and Procter & Gamble, and among the top five in nearly every large U.S. company.
Despite this successful formula, Fink announced in January that the firm was suddenly changing its strategy. “Sustainability” would become “BlackRock’s new standard for investing.” The firm defines sustainability as “understanding and incorporating environmental, social and governance (ESG) factors into investment analysis and decision-making.”
Two years earlier, Fink had drawn wide attention with a letter telling businesses they have to do more than just make profits. “Society is demanding that companies, both public and private, serve a social purpose,” he wrote.
While that letter was dominated by bromides, the new one had surprising specifics. BlackRock is going to jettison companies involved in burning coal. It will make “sustainable funds,” currently a minuscule proportion of the firm’s assets, “the standard building blocks in these solutions wherever possible, consistent with client preferences and any applicable regulations” and its analysts will now consider “ESG risk with the same rigor” they use in analyzing “traditional measures such as credit and liquidity risk.”
BlackRock’s foundational investment philosophy, rooted in index portfolios, had previously been based on the efficient market hypothesis, which holds that today’s share price reflects all possible information. Stock prices move according to what Princeton’s Burton Malkiel famously called a “random walk.” As a result, investors can do better by investing in low-cost, passive portfolios than in stocks that they or others choose because they think shares will appreciate. A study conducted last year by the Institute for Pension Fund Integrity looked at the performance of state pension funds, and determined that only 17 of the 50 states would have outperformed a portfolio made up of 50% in stock index funds and 50% in bond index funds. In other words, over 66% of all state pension funds could not beat a simple benchmark.
BlackRock’s reputation derives not from its ability to pick undervalued stocks or see into the future but from its skill at offering low-cost index investments efficiently. But there’s one problem. Index investing has become a commodity business, with competitors offering undifferentiated funds at wafer-thin margins, and for pension funds, sometimes for free through their custodian.
Investors that follow the efficient market hypothesis and random walk philosophy of investing do not give a hoot about the policies and practices of individual companies as all information is priced into the market almost immediately. It appears that Fink is now rejecting this old credo by assuming that the prices of shares do not properly reflect the threat of climate change, and thus, BlackRock will now make investments that correct for this “mistake.”
No doubt Fink and his colleagues believe in the critical importance of a sustainability screen in their active management, but that explanation is insufficient to explain a change of this magnitude. Instead, the driving force may be simple economics. BlackRock can charge higher fees with both actively and passively managed ESG funds than it can with conventional index funds.
For example, BlackRock’s iShares Global Clean Energy ETF, one of the largest ESG funds in the world, carries an expense ratio of 0.46%. Compare that with iShares Core S&P 500 ETF at 0.04%. A shift to ESG investing would both allow BlackRock to charge higher fees and, from a marketing perspective, distinguish it from competitors like Vanguard, State Street, and Fidelity.
The shift may be BlackRock’s only palatable choice. Right now, the large indexers are in a race to the bottom. BlackRock’s quarterly earnings fell for four quarters in a row on a year-vs.-year basis between the fourth quarter of 2018 and the third quarter of 2019.
BlackRock is making a big gamble. ESG investing has its adherents, but it’s doubtful that it can outperform the standard indexes on which BlackRock has relied for decades. For example, despite the recent decline in oil prices, for the five years ending May 15, BlackRock’s S&P 500 Growth ETF beat the Clean Energy ETF by an annual average of more than 10 percentage points.
Research has consistently indicated that conventional index portfolios perform better than ESG portfolios, partly because ESG portfolios charge higher fees. A Pacific Research Institute study last year, for example, found that for 18 public ESG funds with a 10-year track record, “a $10,000 ESG portfolio would be 43.9% smaller compared to an investment in a broader, S&P 500 index fund.” Only two of the ESG funds would have beat the S&P fund over a 10-year period.
In a 2016 paper, Alicia Munnell, a former Treasury Department official under President Clinton, and now director of the Center for Retirement Research at Boston College, and her colleague Anqi Chen, a researcher at the center,concluded: “While social investing raises complex issues, public pension funds are not suited for this activity. The effectiveness of social investing is limited, and it distracts plan sponsors from the primary purpose of pension funds—providing retirement security for their employees.”
By contrast, Fink is pursuing a course which, while possibly more profitable for BlackRock, puts public pension funds and other client portfolio performance in jeopardy by opening the door to politics as part of pension portfolio management. I have nothing against companies embracing ESG, and in fact, virtually all the leaders and boards of Fortune 500 companies now embrace ESG principles—many for decades. Rather, what I object to is Fink opening the door for politicians to play politics with public pensions rather than adhere to a strict fiduciary standard of the highest returns at a reasonable risk.
If individual investors want to choose social investments, they are certainly welcome, but pension plans shouldn’t be making social and political decisions for their millions of members. Instead, if they are wise, they will pursue the low-fee, index strategy that was the solid foundation on which BlackRock was built, and in doing so, will immediately be in the top third of all state pension plans by performance.
Christopher Burnham has served as the Treasurer of the State of Connecticut, the chief financial officer of the U.S. Department of State, Under Secretary General of the United Nations. He is the founder and president of the Institute for Pension Fund Integrity.