Socially Responsible Investing – the New Wave of ESG Index Funds
By David Dirks and Jamie Osborn
In recent years there has been growing interest in socially responsible investing (now commonly called Environmental/ Social/ Governance, or “ESG” investing), but one of the primary barriers has been the higher cost of ESG investments. As supporters of low-cost index investing, this has made it difficult for us at Plum Street Advisors to recommend a comprehensive ESG portfolio. However, in the past two years, the landscape has seen a seismic shift. Large index fund providers like iShares and Vanguard have launched low cost ESG index funds in a range of asset classes, from stocks to bonds, from domestic to international, and from small to large. The growth of ESG exchange-traded funds (“ETFs”) has been explosive over the past two years, growing from 25 available ESG ETF funds in the market at the end of 2016 to 69 ETF funds at the end of 2018.This explosion in growth of ESG index funds has been enabled by the increasing availability of ESG indexes, which allow large fund providers to create low-cost products based on a passive simulation of an index (much like the Standard & Poor’s 500 Index serves as the basis for low cost S&P 500 funds).
The increasing availability of ESG indexes, in turn, has been enabled by an increase in government, NGO, and corporate reporting on sustainability issues. The push for sunshine regulations (both internal and external) by regulators, nonprofits, activist shareholders and forward-thinking board members has revealed comparable data sets on corporations’ carbon emissions, fair hiring practices, and a wide range of ESG metrics. This has allowed index providers to categorize and rank companies based on a variety of ESG factors for which there simply wasn’t public data even 10 years ago. Years ago, we could have told you which companies made cigarettes or firearms. Today, index providers can generate a ranking of major corporations based on their carbon emissions relative to their overall revenues that updates itself based on regular public filings. As a result, an investor can purchase a US Large Cap ESG Fund at a cost point that is comparable to non-ESG funds. For those whose values align with ESG funds, the question is no longer whether it’s a worthwhile expense to hold ESG funds, the question is how we might make them serve your personal financial goals and how they might fit in your portfolio.
In this paper, we explain why we think the time has come to seriously consider ESG investment. First, we discuss how ESG investment helps to align a portfolio with your values. Second, we talk about the pros and cons of ESG investing: performance, portfolio construction, and cost. Finally, we talk about various approaches to building an indexed ESG portfolio that works for you.
The Case for ESG Investments
There are three primary reasons you might wish to invest in ESG. First, you may have a moral desire to support companies aligned with your values. Second, you may want to influence a company’s actions with your investment dollars. And third, you might believe that in the long run, ESG investments will be more sustainable and therefore have superior long term returns.
First, ESG investing allows you to support, and earn a return from, companies that are aligned with your values. Just as you might not wish to work for a company that doesn’t produce products or services you are proud of, you might decide you do not wish to invest your money in such companies either (“exclusionary investing”). Conversely, you might want to specifically own shares in companies that are aligned with your societal goals (“inclusionary investing”).
Socially responsible funds used to exclude the stocks of certain objectionable industries and then rely on a portfolio manager to build a portfolio from the remaining available companies. The increasing trend in ESG funds is to look more deeply into individual companies and is based on the concept of sustainable investing. While certain industries might still be excluded entirely (i.e. tobacco, weapons, or coal stocks), index ESG funds generally use a ranking system that takes a range of factors into account and emphasizes the inclusion or overweighting of stocks that have the best scores for companies in their industry based on the following key areas:
Second, you may want your investment dollars to influence corporate behavior. When you invest in an ESG fund, you are supporting an entity that may speak with management about its practices, encourage companies to report ESG metrics, and vote proxies that support ESG initiatives or ESG-inclined board members. Companies like to have a diverse set of shareholders supporting the stock and as ESG funds grow in importance, shareholder relations departments are paying more attention to their demands. For example, investors concerned about climate change have helped push companies to adopt the Carbon Disclosure Protocol, which requests information on climate risks and low carbon opportunities. The CDP has 525 institutional investor signatories with a combined $96 trillion in assets as of 2019.
Finally, there are a number of researchers that have made the case that ESG investments will outperform because they are more focused on the long run. They argue that sustainability is important for the public image of a corporation, for serving shareholder interests, and for the pre-emptive insurance effect for adverse ESG events (i.e. non-ESG companies will face higher environmental and regulatory costs and other burdens).
At Plum Street Advisors we believe the jury is still out on relative performance of ESG investments, but that the myth that ESG investments are likely to underperform is an outdated concern (yet one we still hear often from clients). We believe markets overall are efficient and publicly available information is reflected in current share prices in one way or another. Either way, ESG investors should expect their funds to have performance variation from non-ESG benchmarks over any given period – both positive and negative – and that is what we turn our attention to next.
Characteristics of ESG Funds
Traditional socially responsible funds were most often actively managed, meaning decisions were left up to the portfolio manager regarding what to buy and what to sell, and the portfolio managers and their team of analysts tried to spot trends, pick undervalued companies, and construct the overall portfolio the way he/she thought best. Like actively managed non-ESG funds, the high costs of active management had a negative impact on net performance.
The new wave of indexed ESG funds relies on a set of rules to select its investments. All the companies included in the traditional index are ranked based on selected ESG criteria, and the index constructs its holdings based on these rules. The approach is more comprehensive and consistent than the traditional portfolio manager-led approach, but in order to be able to rank every company, it required wide availability of the data the rankings are based on. This company ESG data has become vastly more available, which has helped to drive the growth of ESG index funds. The resulting index funds, just like their non-ESG counterparts, are significantly cheaper to run and are much more predictable as far as how they will behave as compared to the overall market.
Building an “Optimized” ESG index (illustrative MSCI USA example):
To understand an ESG index, you really need to understand the underlying index it is seeking to match. Some ESG indexes are constructed to closely track a standard benchmark (for example, the iShares CRBN ETF tracks the MSCI ACWI Low Carbon Target index, whose twin objectives are to minimize the carbon footprint of the companies it holds while closely tracking the annual return of the standard MSCI ACWI index). Other indexes are less concerned about matching the performance of a standard index in the short run. We turn to this issue now.
Performance and the Issue of Performance Deviation in ESG Index Funds
ESG index funds seek to closely track the performance of a specifically-designed ESG index. The attributes of the funds will depend entirely on the construction of that index. The issue of performance deviation has more to do with how closely the ESG and standard indexes track each other than how closely the fund tracks its index. This offers an advantage in the analysis because even though many ESG index funds are relatively new and have little track record to review, the index rules can be applied retroactively and can give a longer term sense of how performance is likely to compare to the standard counterpart index.
Below are two index funds with very different methodologies. The Vanguard fund tracks an “exclusionary” index which excludes tobacco, weapons, gambling, and other industries and screens all stocks for environmental, labor rights, and other issues. It then constructs an index using traditional methodologies with the companies that survive the screens (most Vanguard ESG index funds work this way). This leads to a fair amount of difference in performance between the two indexes. The iShares fund relies on an MSCI index that uses a different approach. The MSCI index ranks companies by their emissions (as a percentage of sales) and then uses an algorithm to find a portfolio with the lowest emissions that meets a predetermined amount of performance variation from the standard index.
The point of the above is not to get lost in the myriad different methodologies for creating indexes, but to emphasize that in order to get a sense of how a portfolio will behave, one needs to understand how much the individual indexes differ from a standard index.
One must further keep in mind that the performance variation of ESG indexes is not random. Generally speaking, ESG indexes have certain characteristics as compared to their non-ESG counterparts. They have a tilt toward growth stocks because they are often over-weighted in “clean” sectors like IT (although most will limit how much overweight they can be in any sector), and they tend to move in the opposite direction of certain “factors” (like oil prices) because they favor companies with less energy exposure. These characteristics may cause a portfolio of ESG funds to behave differently, albeit in somewhat predictable ways compared to a portfolio made up of more traditional indexes. In the following chart, we have compared a sample ESG portfolio’s performance to a similarly-allocated standard model portfolio. Notice that the sample ESG portfolio indicates lower relative return than the standard portfolio in 2016 (when value stocks did well) and indicates higher relative return in 2017 and 2018 when growth stocks did better:
At Plum Street Advisors, we can help you to estimate just how far off an ESG portfolio is likely to stray from a more standard portfolio in a given month or year, and adjust the mix depending on your tolerance for this so-called “tracking error”.
Another characteristic of ESG funds is a difference in cost. As mentioned previously, traditional ESG funds were mostly actively managed and much more expensive than the types of passively-managed portfolios we use at Plum Street Advisors. The Calvert Equity Fund, a large traditional ESG fund for US stocks, has a net expense ratio of 0.99% for the Class A shares, and 0.74% for the institutional class. But the large number of index-based funds recently introduced are far less expensive. The Vanguard ESG U.S. Stock ETF, launched in September 2018 has an expense ratio of just 0.12%, while the iShares ESG MSCI USA ETF, launched in December 2016, has a similarly low expense ratio of 0.15%. Standard index funds and ETFs are still a bit lower cost, but these new funds make an index ESG portfolio competitive in price.
A Customized ESG Portfolio
Building an ESG portfolio is a more personal, customized endeavor than building a traditional portfolio. Not only do we have to consider risk and return, but we also need to consider which environmental, social, and governance issues are important to the client and how much deviation from standard performance the client is willing to accept. The good news is that the new wave of ESG funds has given us much wider choice of funds and asset classes at much better pricing and with much greater transparency (since the fund has to be clear about the rules built into the indexes), allowing us to build diversified, low-cost, transparent portfolios.
For many years, ESG has been a much greater percentage of the talk of investors than of their dollars. Institutional ownership of ESG portfolios was largely the domain of either religious institutions or portfolios with very limited exclusions (like tobacco-free funds). This is now rapidly changing, as ESG investing has caught on and the cost of ESG investing has declined dramatically.
The growth of ESG—led by European pension funds and insurers— is increasingly being adopted by US institutional investors, and will likely be followed by more material retail growth in ESG mutual funds and ETFs There are now over 350 ESG mutual funds and ETFs available, representing $89 billion in assets. The ground-breaking change from our perspective is that many of these ETFs are based on broad indexes at low fees and it is now possible to build ESG portfolios using mutual funds and ETFs in almost every asset class that are competitive with portfolios based on standard indexes.