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ESG Funds: Impact and Alpha

These ETFs show that an adherence to companies with high-ranking environmental, social and governance scores produce more reliable earnings and can outperform the market.

Remember when your mom told you to eat your vegetables? “They’re good for you,” was the usual refrain. Turns out she was right. Veggies are good for you. And so are ESG-focused investments, according to recent evidence.

ESG? Investments predicated upon environmental, social and governance best practices evolved from what was once known as socially responsible investments. In its day, SRI was essentially a subtractive process. An investment universe such as the S&P 500 was combed to cull “vice” or “sin” stocks—companies engaged in the tobacco, booze, gaming or aerospace/defense industries—to create a portfolio. The practice ultimately led to chronic underperformance. It’s no wonder why. Often, the sin stocks were the ones that fared best in market upcycles.

ESG-focused investment tends to be more proactive, purposefully seeking out those companies that follow best practices with regard to:

  • Environmental performance related to pollution, climate change, recycling and the like;
  • Social criteria impacting the company’s relationships with employees, suppliers, customers and communities in which they operate; and
  • Governance with respect to company leadership, executive pay, internal controls and shareholder rights.

Theoretically, adherence to ESG best practices should reduce litigation and regulatory risk, and lead to better business performance. While some believe that the ESG metric is too blunt of an instrument to rely on exclusively when trying to build a truly sustainable portfolio, there’s a growing body of research that shows high-ESG-scoring companies actually produce more reliable earnings and can outperform the market. Recent launches of ESG-focused exchange traded funds reinforce these findings. 

Your Choice of Veggies

Four ETFs tracking the broad swath of U.S. companies with high ESG scores were launched in 2016, joining two veteran portfolios. The question to be addressed for investors is whether these funds can be effectively used as broad market stock allocations in lieu of more traditional exposures.

On the basis of its 2005 launch date, the iShares MSCI USA ESG Select Social Index Fund (SUSA) is considered the granddaddy of ESG-focused ETFs. The fund, however, began life as a subtractive SRI product which, until 2017, traded under the ticker symbol KLD. DSI’s index methodology now screens the MSCI USA Index for companies ranked highest for their socially conscious values on the environment, community relationships and corporate governance. The resulting portfolio—numbering some 103 stocks—is optimized to overweight high-ESG-scored companies and underweight lower-ranked firms while maintaining a reward/risk profile similar to the MSCI USA Index. Toward that end, individual security weights are capped at 5 percent and sector deviation is limited to 3 percent.

As of May 2018, SUSA earned an MSCI ESG Fund Quality Score of 8.34, making it the highest-ranked among our six-fund universe. The ESG Quality Score measures, on a scale of 0 to 10, the capabilities of a fund’s component companies to manage key medium- to long-term ESG risks. The MSCI scoring rubric offers greater granularity than Morningstar’s five-tiered Sustainability Ratings. As a benchmark, the SPDR S&P 500 ETF (SPY) advertises a 5.28 ESG Fund Quality Score.

The iShares MSCI KLD 400 Social ETF (DSI), originally floated in 2006, sweeps the NYSE and Nasdaq markets for stocks with positive ESG characteristics, filtering out companies involved with tobacco, alcohol, civilian firearms, nuclear power, military weapons, adult entertainment and genetically modified organisms. Companies passing the screen are then ranked by ESG criteria with the top 400 tapped for inclusion in the market cap-weighted portfolio. At last look, DSI received a 6.47 ESG Quality Score.

Oldest among the novice funds is the Global X S&P 500 Catholic Values ETF (CATH), which combs through its namesake benchmark to jettison those issues not comporting with Catholic values. Companies deriving revenues from the manufacture or marketing of unconventional weapons, contraceptives and pornography are tossed, as are firms involved with abortions, stem cell research and child labor. Tracking error is minimized by matching sector weightings with that of the S&P 500. The result is a 458-stock, cap-weighted portfolio reminiscent of the old SRI model. CATH’s ESG Fund Quality Score, at 5.28, is the lowest in our universe and identical to SPY’s. Effectively, that means there’s no ESG benefit derived through an investment in CATH. You invest in CATH because you want your target companies to adhere—to some degree or another—to Catholic social values, regardless of their environmental or corporate governance practices.

Global X Funds takes another bite of the apple with the equal-weighted Global X Conscious Companies ETF (KRMA). This fund plays up the “S” and the “G” in ESG by focusing on companies dedicated to providing positive outcomes for five key stakeholders: customers, suppliers, stock and debt holders, local communities, and employees. To qualify for inclusion in the KRMA portfolio, companies must have a three-year track record of exhibiting positive social and corporate governance characteristics as reflected by their employee productivity, executive integrity, customer loyalty and the quality of their financial reporting, among other metrics. By limiting its investment universe to U.S. companies with market capitalizations of $2 billion and more, KRMA’s 140-stock portfolio has a definite large-cap tilt. KRMA now boasts a 6.10 ESG Fund Quality Score.

The FlexShares STOXX US ESG Impact Index Fund (ESG) holds more than 250 U.S. stocks gleaned from the STOXX Global 1800 Index. Key performance indicators include policies favoring independent and female board members, the avoidance of golden parachute agreements, low pollutant emissions and rules against child labor, among others. Coal mining companies are automatically excluded as are firms involved with controversial weaponry. Also disqualified are outfits that don’t adhere to the principles embodied in the United Nations Global Compact. The portfolio is cap-weighted with individual security allocations capped at 5 percent. In May, the FlexShares portfolio registered a 5.63 ESG Fund Quality Score.

Like SUSA, the MSCI USA Index is the investment universe from which components of the iShares MSCI USA Optimized ETF (ESGU) are lifted. ESGU’s index methodology’s first cut takes out companies involved in the tobacco business and those engaged in the production and retailing of certain weapons as well as firms embroiled in very serious business controversies. Then, a quantitative process determines the optimal weights of the remaining companies that will maximize high ESG exposure while maintaining the risk and return characteristics of the MSCI USA Index. ESGU rates a 6.50 ESG Fund Quality Score. 

Tasting Results

Over the past 12 months, all the broad-based ESG-focused ETFs outperformed the market as represented by SPY. Our six-fund universe beat the blue-chip market’s gross and risk-adjusted returns, and each ETF earned positive alpha by varying degrees.

At the top of the table is KRMA, which earned a significant premium over the market while providing holders a relatively smooth ride. The fund’s equal weighting scheme contributed greatly to KRMA’s outperformance, allowing the impressive gains from tech stalwarts such as Texas Instruments and Automatic Data Processing, financial firms like T. Rowe Price, and drugmakers epitomized by AbbVie, to drive returns. KRMA truly marches to its own drumbeat. Its r-squared and beta coefficients are the lowest of all the ETFs, putting considerable daylight between the Global X portfolio and the SPY market proxy. KRMA’s 3.65 alpha coefficient is also impressive, engendered in part by the portfolio’s relatively low volatility.

If there’s a negative to be found in KRMA, it’s that it lacks the ‘E’ in ESG. Investors seeking explicit environmental best practices in their target companies need to look beyond KRMA. Perhaps not too far, though. Just a notch below KRMA in our table is SUSA, which seems to fit the entire ESG bill. Yes, there’s a return give-up—SUSA outdid SPY by only 47 basis points—but the iShares ETF’s volatility is comparable to KRMA. That’s not surprising, given SUSA’s mandate. KRMA, recall, has no requirement to hug the market’s return and risk parameters.

The FlexShares ESG portfolio is also worthy of consideration, if for nothing more than its relatively low r-squared coefficient. That may prove to be a buffer in a bearish market environment.

At the table’s bottom is the DSI. While DSI, with its 6.47 Fund Quality Score, does yeoman’s work as a responsible investment, it offers a very thin edge on the market. Still, an edge is an edge. Even if one was only looking for an ESG-focused investment with a market-like return, DSI would likely suffice.

Pushing Away from the Table

So, are ESG-focused ETFs the veggies in our investment menu? Well, some clearly look better on the plate than others, but over the past year all have been clearly good for us.

Thanks, Mom. 

Brad Zigler is WealthManagement’s Alternative Investments Editor. Previously, he was the head of Marketing, Research and Education for the Pacific Exchange’s (now NYSE Arca) option market and the iShares complex of exchange traded funds. 

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