Benjamin M. Lavine, CFA, CAIA
Note: an edited version of this article first appeared on ETF.com
Investing in strategies built around Environmental, Socially-Conscious/Social Awareness, and Governance principles (ESG) has gained increased popularity over the last decade as great strides have been made around data collection and standardization. Investors and asset allocators can feel more comfortable today building ESG-focused programs that are more globally diversified and built on more objective, standardized data, and less easily swayed by individual judgments.
There are several data providers competing for the ‘VHS/Betamax’ stamp for industry standardization, with Sustainalytics and MSCI emerging as the two primary research providers. The former serves as the data engine for Morningstar’s Sustainability and ESG ratings while the latter provides ESG data for financial engines like ETF.com (Dave Nadig referenced MSCI ESG ratings aggregated up to the ETF portfolio level in “Your Stealth ‘ESG’ Portfolio, 7/19/2019”).
In this article, our goal is not to advocate for or against ESG-based approaches for asset allocation and investment selection, but rather to emphasize the importance of understanding what biases are built into an ESG-aligned program beyond the direct themes stated in the prospectus or investment policy statement. We also conclude with some thoughts on where we would like to see a marrying of ESG and smart beta methodologies.
ESG Investing in a Nutshell
The goal of ESG investing is to maximize participation in companies focused on sustainable business practices while earning competitive returns for their shareholders. It is to better align investment portfolios with client values that are largely captured in these three categories (source: Investopedia.com):
- Environmental: energy use, waste, pollution, natural resource conservation, and treatment of animals.
- Social Awareness: labor practices, board and management diversity, working conditions.
- Governance: accounting practices, litigation risk, conflicts of interest.
Progress has been made by data researchers to more systematically capture and judge corporate practices and then standardize that data versus peers (i.e. energy sector peer groups). According to Sustainalytics, more granular data collection and greater transparency brings more light to corporate business activities. ESG research providers such as Sustainalytics have evolved rating methodologies to focus more on material financial risks, or the degree to which a company’s economic value may be at risk driven by ESG issues.
Fund data providers such as Morningstar and ETF.com subscribe to ESG data researchers to aggregate ESG ratings at the fund level. Funds generally must hold a certain minimum weighted-percentage threshold of ESG-covered companies in order to receive an ESG fund rating.
Currently, the ‘ESG fund category’ is somewhat nebulous given that ESG can encompass both qualitative themes (i.e. clean energy) and traditional market-based approaches (i.e. the MSCI ESG Indices). Figure 1 is a list of ESG ETFs as categorized by ETF.com. The broad-based market ETFs are dominating overall assets, likely due to low fees and core market exposures.
Figure 1 – Top ESG-Focused ETFs
Source: ETF.com Screener & Database using ESG filter under Features
Should Investors Be Compensated for Taking ESG Risk?
Proponents of efficient market investing may argue that investors should expect lower returns when investing in highly rated ESG companies that operate with lower financial risk. In a rational capital market, investors should not be compensated for taking on lesser risk. Highly rated ESG stocks tend to trade at premium valuations versus the broader market, but this could be cyclical rather than structure. ‘Value’ is a risk factor that has historically produced excess returns.
However, highly rated ESG stocks also tend to produce higher returns on capital and are more highly profitable. Academic research has shown ‘profitability’ to be historical rewarded with higher excess returns (see Fama/French/Novy-Marx).
3 in 1 – 1 in 3?
What one tends to see is that the E/S/G category fund scores are highly correlated to one another suggesting a fair degree of intersectionality across E/S/G. In other words, a fund that is highly scored in the Environmental category will also likely have high scores across Socially-Conscious and Governance categories. One wonders whether there is a methodological bias to the scoring process. Can a coal mining company with a poor Environmental score receive a higher score in Socially-Conscious and Governance? Are ESG investors really getting exposure to three distinct categories or just one super category?
Asset Allocation: Stacking the ESG Deck
Using exchange-traded fund (ETF) data from Morningstar, we produced average overall and individual ESG category scores for various equity fund categories which are displayed in Figures 2a and 2b. Morningstar ESG Scores range from the mid-30s to the mid-60s. We want to focus attention on the yellow-highlighted categories.
Figures 2a and 2b – ETF Fund Categories: Average Morningstar ESG Fund Scores
Source: Morningstar (8/31/2019)
Some interesting observations stand out:
- European-focused funds tend to score at the top while emerging market funds (primarily China and India) tend to score at the bottom.
- Large cap funds score better than mid-caps which score better than small caps. In fact, small cap funds tend to have worse scores than emerging markets.
- No real significant difference between value and growth funds, which is a little surprising given the factor loadings mentioned earlier.
Given that Europe largely berthed the ESG movement and has pretty much mandated it across a significant portion of the investor base, it should come as little surprise that European stocks tend to rank the highest among major regions. Although company coverage is improving, we suspect that large cap funds tend to score higher than small cap funds due to lower breadth of data coverage across the small company universe (that and larger companies are more likely able to shoulder the increased compliance and reporting requirements of monitoring and tracking ESG-relevant operating metrics).
Granted, most asset allocators incorporating ESG will adopt a relative approach rather than an absolute approach so as not to sacrifice diversification for the sake of pursuing ESG goals (or you end up with a concentrated U.S./European large cap program). However, this also risks the watering down of the ESG impact that many clients are starting to value as much as they value achieving their financial goals. At the very least, advisors should disclose and explain these trade-offs with those clients seeking to incorporate ESG principles into their programs.
Integrating ESG with Smart Beta
Finally, we have some final thoughts on integrating ESG with factor investing or smart beta. There has been some interesting research published by the likes of MSCI and AQR on improving factor scoring methodologies by removing the ‘junk’ from the eligible universe before applying the scoring rules or factor optimization.
Applying ‘junk’ screens to any rules-based approach, whether simple market-cap weighting or smart beta, to improve risk-adjusted performance could be an intriguing way of incorporating ESG principles while not sacrificing too much of the original mandate. However, for the quant artist, it’s a fine line between ‘conditioning’ a factor versus turning it into a Frankenstein amalgamation. We think there could be more interesting research into integrating ESG with traditional smart beta approaches.
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