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ESG Investments – Part Two: What You Need to Know Before Investing

By Matt Kelley, CFA, Portfolio Strategy Manager
& Chris Sardi, CFA, Portfolio Strategy Analyst

ESG (environmental, social, and governance) investing is still new and represents a very small part of the investable fund market in the U.S.; however, the space is growing at an exponential rate. In part two of our ESG investments series we’re going to cover everything you need to know by homing in on ESG categories, ratings, and how they affect returns.

ESG Investing

The landscape of sustainable funds can be broken down into two categories: funds that consider ESG factors and funds that have an ESG/Sustainable focus. Consideration funds are funds that simply mention ESG as part of their investment strategy, and focused funds refer to funds in which ESG is a core part of the investment process. Many fund managers are adding an ESG consideration to investment strategies already in existence. This can be as little as adding a line in the prospectus that includes ESG factors as one of the many elements used in making their investment decisions.

The landscape of sustainable funds can be broken down into two categories: funds that consider ESG factors and funds that have an ESG/Sustainable focus.

Morningstar Inc. does a good job of defining a “sustainable fund landscape.” According to Morningstar, there are 564 ESG “consideration” funds and 303 ESG “focused” funds in the U.S., which spanned all asset classes at the end of 2019.

There is now about $1 trillion in assets under management in ESG consideration funds. The number of ESG consideration funds increased from 81 to 564 in 2019, demonstrating how crucial ESG considerations have become for investors and the desire for fund managers to meet this new demand. A lot of the rise in ESG consideration funds is from managers editing the prospectuses of existing funds to mention ESG in the investment process; how much, or even if these funds have actually “changed” isn’t always clear.

The rest of the funds (about 300) are funds that have ESG investing as a core part of their investing process. About 100 of these are focused on U.S. equity.

Lastly, passive funds make up one third of the universe. If you look at US Equity, there are 14 passive mutual funds and 26 passive ETFs (exchange-traded funds). That’s not many options for someone who wants passive exposure to ESG in the U.S., when we consider how many different ways there are to measure ESG.

Hale, Jon. “Sustainable Funds U.S. Landscape Report.” Morningstar Research, 14 February 2020.

ESG Categories Preclude

ESG funds differ by the way the portfolio is constructed and by the way securities are defined within an ESG framework. Generally, strategies for ESG investing can be broken down into the following categories:

  1. Negative screening (exclusionary) – these strategies aim to exclude stocks based on ESG-related criteria. This could be a portfolio that excludes “sin stocks,” or a portfolio that removes securities that don’t meet some minimum ESG rating/criteria.
  2. Positive screening (inclusionary) – these strategies look for companies that meet certain ESG requirements and only include them in the portfolio.
  3. Tilting – these strategies still invest in the entire applicable investment universe, but “tilt” the portfolio so investments with higher ESG ratings represent larger holdings within the portfolio.
  4. Thematic strategies – thematic investing generally targets a specific ESG factor or industry, such as climate change or energy efficiency.
  5. Impact investing – an impact strategy invests with the purpose of generating an ESG impact as well as a financial return. This would include funds that target specific investments for their ESG impact (e.g., green bonds).

ESG funds generally fit into one of these categories or use a combination of multiple categories. Most passive or index funds will use some combination of tilting and negative screening. For example, a fund may first exclude all tobacco, gun, and gambling companies, and then tilt the remaining portfolio toward higher-rated ESG companies.

How are ESG Funds Rated?

Most funds, whether active or passive, incorporate some type of ESG rating to execute their strategy. Ratings are either done in house or are outsourced to a third party. SustainAbility (a sustainability/ESG consulting firm) estimates that there are over 600 ESG rating methodologies globally. Some common rating companies include RobecoSAM, Sustainalytics, Refinitiv, MSCI, and FTSE Russell, but these ratings aren’t all one and the same. They can sometimes differ quite significantly—there are times when the same stock has a poor rating at one rating agency and a good rating at another.

One specific example is Tesla. Tesla’s environmental score, for example, has the lowest possible rating according to FTSE Russell, but the highest rating according to MSCI. This is because FTSE rates them purely on emissions from factories while MSCI rates them mainly on emissions from its cars and opportunities in clean technology, a subtle difference in methodologies that results in a huge difference in ratings. Other rating agencies have conflicting scores as well. JUST Capital, a rating company which surveys the public to determine exactly how much to weight each ESG issue, ranks Tesla in the bottom 10% of all companies. This is primarily because (as a result of its surveys) it weights workers/social issues much higher than environmental issues. Sustainalytics and MSCI on the other hand give Tesla an overall score that is around average, since it weights environmental, social, and governance issues equally.

One issue with ESG ratings is transparency...because qualitative information and data are a large part of the rating, investors should be aware that there is some subjectivity associated with almost any ESG rating.

One issue with ESG ratings is transparency. Most firms have publicly available methodologies that discuss their rating process and scoring methodology. However, because qualitative information and data are a large part of the rating, investors should be aware that there is some subjectivity associated with almost any ESG rating.

How ESG Investing Affects Returns

There’s a great deal of research out there attempting to draw connections between ESG investing and returns; however, there’s no common verdict as to whether ESG affects returns, and if it does, in what direction. Research studies differ by many things, including the time period used, the ESG rating methodology used, the way performance and/or risk is measured, the benchmark used, and how other variables are controlled including elements such as risk factors and industry/region exposures.

The Sustainability Accounting Standards Board (SASB), which was founded in 2011 to develop and disseminate sustainability accounting standards, has created a set of metrics which they have deemed material to an investor, or in other words, factors that should in some way affect the financial performance of a company. There is some overlap with SASB’s metrics and the metrics used by different ESG rating companies such as Sustainalytics, MSCI, and RobecoSAM.

Some of these overlapping topics include emissions, climate impacts, energy management, human rights, data privacy, employee wellbeing, supplier relations, and business ethics. There is certainly rationale behind why these factors could affect the financial performance of a company. A heavy polluter has a much higher risk of regulatory intervention that could threaten their operations; poor business ethics or accounting practices increase the likelihood that a company overestimates earnings; a company with poor energy management will be negatively impacted as energy prices increase in the long term.

ESG Funds in Action

To get an idea of how ESG portfolios perform in practice, we can look at the performance of common benchmarks. We have compiled a few common ESG indexes to see how they have performed against traditional benchmarks. Broadly speaking, returns do not seem to be diminished from using an ESG strategy. With that being said, robust historical data going back further than 10 years is difficult to find.

ESG Indexes 1 Year 3 Years 5 Years 10 Years
DJ Sustainability US Composite 9.9% 11.2% 12.8% 12.4%
FTSE4Good US Select 14.2% 12.7% 13.2% 14.3%
FTSE4Good US 12.9% 12.6% 13.4% 14.2%
MSCI KLD 400 Social 12.4% 11.5% 12.2% 13.0%
MSCI USA ESG Focus 13.2% 5.8% 11.7% 12.5%
MSCI USA ESG Leaders 10.1% 10.6% 11.7% 12.3%
MSCI USA ESG Universal 12.9% 11.5% 12.2% 12.7%
Traditional Benchmarks 1 Year 3 Years 5 Years 10 Years
Russell 1000 10.9% 10.6% 11.8% 13.1%
Russell 3000 10.2% 10.0% 11.5% 12.8%
S&P 500 9.7% 10.4% 11.7% 13.0%

*Chart performance as of 10/30/2020

The performance of funds or indexes can be driven by a multitude of factors. For example, the FTSE4Good indices have consistently outperformed tradition benchmarks. However, this outperformance may not be entirely tied to ESG factors. A closer look shows that ESG’s lack of sector constraints results in higher growth and technology exposures—these are exposures that have outperformed the S&P over the last 10+ years, but are not guaranteed to outperform in the future.

With this in mind, it can be useful to compare sector neutral indices to better isolate how ESG investing might drive performance. The DJ Sustainability U.S. Composite is sector neutral to the benchmarks and has one of the longest track records. Performance is a little mixed as we see outperformance over the last five years or so, but underperformance if we go back 10 years.

While the recent outperformance of these indexes looks appealing, it’s too early to jump to any conclusions, especially when many indexes do not have performance data that spans a full market cycle. Further, it is difficult in most instances to tie outperformance to the actual ESG element of the index; there are many other factors and variables that affect returns that investors should be aware of.

Traditional investing primarily focuses on two dimensions: risk and return. However, ESG investing involves a third variable: values.

While it’s not yet clear whether ESG strategies will outperform traditional ones over the long run, ESG can still be beneficial to many investors. Traditional investing primarily focuses on two dimensions: risk and return. However, ESG investing involves a third variable: values. It’s relatively straightforward to quantify risk and return, but quantifying values is difficult. The most important thing to know before making any investment is what you are investing in, and it is no different when it comes to ESG. Just as an ESG investor needs to understand the risk and expected return of a potential investment, they must also understand how it aligns with their values.

Click here to read Part I of this two-part series: An Introduction to and History of ESG Investing.

About Matt Kelley, CFA
Matt Kelley is a Portfolio Strategy Manager with ESL Federal Credit Union. In his role, Matt oversees the portfolio strategy team at ESL and is responsible for the investment philosophy, approach, and overall performance of internal and external investment portfolios for ESL.

About Chris Sardi, CFA
Chris Sardi is a Portfolio Strategy Analyst with ESL Federal Credit Union. In his role, Chris is responsible for managing the development and coordination of research and due diligence/guidance on investment products for internal and external portfolio construction and management for ESL.