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Inside ETFs Conference
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A think tank at the Inside ETFs Conference focused on ESG and socially responsible investing.

The Active Decisions Behind Passive ESG Indices

Tesla’s removal from the S&P 500 ESG Index should tell advisors that while the index strategies may be data driven, they are still subjective.

It didn’t start out well for the session titled “The Truth about ESG” at the Inside ETFs portion of the WealthManagement EDGE conference.

ESG indices are proliferating, filtering companies based on environmental, social or governance scores that may impact a company’s future performance but aren’t reflected on a financial balance sheet. Many asset managers and advisors use ESG as a short-hand to build portfolios that align with an investors’ personal values on the environment, worker’s rights or corporate governance structures, among other factors.

The problem is while there is a tidal wave of data informing ESG metrics, there is no widely accepted rating system to determine what makes a company “good” or “bad” when it comes to the non-financial factors being tracked.

Just before the Inside ETFs conference, S&P Dow Jones Indices had just removed electric-car manufacturer Tesla from their ESG index, tracked by the SPDR S&P 500 ESG ETF (EFIV). The move underscored how subjective “truth” is when it comes to the passive, data-driven investment screens.

“I tweeted a Bloomberg article that said the S&P index committee kicked out Tesla from the index,” said moderator Eric Balchunas, senior ETF analyst at Bloomberg and author of the new book, “The Bogle Effect,” about Vanguard founder John Bogle.

He then tweeted a screenshot of stocks remaining in the index, which included Exxon Mobil, soda manufacturers, and other companies that don’t at first glance fit a common perception of companies with good ESG scores.

“Lo and behold,” he continued, “Elon Musk replied to this tweet and said, ‘What is going on? S&P should ashamed. ESG is an outrageous scam!’ ”

“Why is he wrong?” Balchunas asked the panel.

“I think ESG should be recognized for applying more data to the investment process. How can that be a bad thing? Bringing more data to bear in the investment process?” asked Reid Steadman, managing director and global head of ESG & innovation at S&P Dow Jones Indices, sidestepping the question.

“We see institutional and individual investors are very interested in what’s in the company beyond the traditional financial statements,” he continued. “Investors want their values reflected not just in the car they drive and the food they eat, but also in the investments and indices they use. For that reason alone, it’s critical we take this very seriously. That there be benchmarks, funds and other tools for investors to reflect their preferences.”

“Tesla is complicated,” said Hernando Cortina, head of index strategy at Institutional Shareholder Services’ ESG data service. He said ISS ranks Tesla in the top 10th percentile of ESG firms, making it “prime,” or a best of class, in the auto industry.

Yet, Tesla has a red flag: A verified National Labor Relations Board violation against unionization in California, Cortina told the audience.

He added that if his company’s rule said only companies with no human rights controversies are acceptable for an index, then Tesla would be out. But by focusing on Tesla’s “E” in the ESG rating scale, it stays in the index because of the positive impact of its products. (Other ESG data providers ding Tesla’s “E” rating due to the amount of carbon-based energy required to charge the electric cars’ batteries.)

“Do you only want to purely rely on a holistic rating,” Cortina asked, “or do you want additional factors that may matter to you but not to others?”

“Which speaks to the subjectivity of values,” replied Balchunas.

“It’s very subjective and not black and white. It’s hard to say this is an ESG company and this is not,” said Jonathan Bauman, vice president and senior client portfolio manager at American Century Investments.

Bauman said American Century held Tesla in its active portfolios because of the environmental benefits of its products. However, social concerns can lead to governance issues, and oversight and independence concerns might cause the American Century to underweight it relative to a broad market index.

Balchunas said one of Steadman’s colleagues wrote a blog post explaining why Tesla was kicked out of the index. It had more to do with the social and governance aspects, than the environmental impact (or lack thereof). He added that ESG analysts at Bloomberg Intelligence backed that assessment.

Balchunas said focusing on how one stock gets treated by the data providers shows the subjectivity in the ESG process and why advisors need to know how the system works to create portfolios for their clients who may want values-aligned investments.

Cortina said it was more important for individual firms that rate companies for ESG be consistent with their own approach, as opposed to declaring that approach is the only one that matters.

“If the index says you don’t include tobacco producers or retailers then that’s a rule and it’s fixed and you never have to question why a company is in or out,” said Cortina. “That provides a lot of clarity for the investor on   what exactly they are getting with ESG. If you want transparency on what an index will do, it’s nice to have it written out in black and white.”

After the session Balchunas spoke with and said, “All the ESG scorers missed a huge opportunity with this Tesla thing to talk about what they think ESG is and give transparency to their method. There’s a massive perception gap and they don’t seem to care.”

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