The New Rules for ESG

ESG has become popular, even over-hyped, and is seeing significant flows. Same as the smart beta hype a few years ago. What should you be aware of to avoid disappointing outcomes?

The popularity of environmental, social and corporate governance (ESG) investing, also known as sustainability investing, has grown tremendously over the last decade alongside our increasing desire to be better citizens: protect the environment, be more engaged with social issues, and hold corporations accountable for their business decisions. Having gained popularity in Europe initially, ESG investing is now quickly gaining momentum around the world. In the US, the ESG ETF flows have tripled in 2020 to a total $40 billion1, while in Europe the flows have almost doubled to a total of $32 billion2.

We like the concept of ESG investing, especially for our readers seeking allocations that align with their ethical beliefs or organizational values. However, remembering the hype around smart beta several years ago and its subsequent disappointing returns, readers ought to be mindful of what they are purchasing. Here are some rules that we think would be helpful:

  • Evaluation: pay attention to the index methodologies

  • Skews: be aware of stock/sector biases

  • Grounded: valuations should be rational and sensible

Evaluate the Methodologies

At present, there is little uniformity across indices branded as ESG and many different approaches are being used, some of which may compromise the “purity” of the ESG profile. Typically, the constituents of an ESG index are selected based on their “ESG company score”, i.e., companies with the highest ESG scores will be included and those on the opposite end will be excluded. However, there may be some more less obvious approaches that readers should be aware; for instance:

  • There may or may not be a sub-sector filter to exclude more controversial industries such as tobacco and armaments;
  • There may or may not be carbon metric exclusions;
  • Some ESG indices aim to be broadly neutral to the benchmarks by having the same sector compositions, while others may ignore sector compositions;
  • There is no standardized ESG scoring system among the index providers - they have partnered with (or acquired) different ESG rating companies, each of which has their own unique scoring process and approach;
  • Some indices may or may not be aligned to internationally recognized environmental accords such as the Paris Climate Agreement.

Obviously, different ESG index designs and constructions can result in widely different constituencies and investment outcomes. Readers should “evaluate” the ESG indices based on their preferences and values before committing to any decisions.

Skews Assessment

The lack of common methodologies can also present substantial compositional (sector and stock) differences among ESG indices, a key factor in performance and returns. A recently published MIT paper titled “Aggregate Confusion: The Divergence of ESG Ratings” only found an average correlation of 0.61 between ESG scores – a relatively low number which suggests there is scope for big differences in ratings. By comparison, credit ratings from Moody’s and Standard & Poor’s are actually quite similar and have a correlation of 0.99.

Sector Skews

ESG metrics tend to score mature manufacturing companies in the utilities, energy, materials and industrial sectors unfavorably.  These companies typically have large plants, brownfield sites or extraction processes that can be difficult to convert to cleaner production methods. In contrast, technology, consumer discretionary, healthcare and financial companies present less environmental hazards and in turn score better on ESG metrics.  As a result, these sectors are usually overweighted in ESG indices as highlighted in the table below. We take the average weight of an ESG sector from five popular ETFs, less the benchmark weight then divide that by the benchmark weight to show which sectors are usually under or over weighted.

This disparity can create a material impact in terms of index performance. In fact, the stellar performance of the technology, consumer discretionary and healthcare sectors during the Covid-19 pandemic has contributed significantly to the ESG outperformance of late.

 

                                                                                     Source: The Index Standard, November 27, 2020. Indices analyzed: FTSE US All Cap Choice Index, MSCI KLD 400 Social Index, MSCI USA Extended ESG Focus Index, STOXX USA ESG Impact Index, S&P 500 ESG Index. Benchmark: S&P 500 Index.

Stock Skews

The lack of uniform rating and scoring means that the same stock can be treated very differently by index providers. For large-caps such as Amazon and Johnson & Johnson, they may have a high ESG rating from one index provider and be included in their ESG index, but the opposite can also happen. The issue is, given their size, the inclusion/exclusion of Amazon or Johnson & Johnson will inevitably have a material impact on an index’s performance. For example, Amazon is included in four of the five most popular US underlying ETFs and Johnson & Johnson is included in just one of them.

Grounded in Valuations

Given the popularity and flow of money into ESG indices, valuations can get distorted. When we compare the price to earnings ratios of the major ESG indices to the average of two major US benchmark indices, the ESG indices are currently trading at a 10% premium, which may indicate a 10% potential for lower ESG index returns.

ETF Name

Index

Price to Earnings Ratio

Vanguard ESG US Stock ETF (Ticker: ESGV)

FTSE US All Cap Choice Index

   25.09

iShares MSCI KLD 400 Social ETF (Ticker: DSI)

MSCI KLD 400 Social Index

   26.05

iShares ESG Aware MSCI USA ETF (Ticker: ESGU)

MSCI USA Extended ESG Focus Index

   25.01

FlexShares STOXX US ESG Impact Index Fund (Ticker: ESG)

STOXX USA ESG Impact Index

   32.3

SPDR S&P 500 ESG ETF (Ticker: EFIV)

S&P 500 ESG Index

   24.1

Average

 

   26.5

S&P 500 Index/Russell 1000 Index

 

   24.1

                                                                                                                                                                Source: The Index Standard, November, 2020.

As mentioned earlier, technology, communication services and healthcare sectors are usually overweighted in ESG indices and they have performed well during the Covid-19 pandemic.  Once the Covid-19 vaccine is distributed and puts an end to the pandemic and things return to normal, there is always the possibility that these sectors will revert back to their pre-Covid valuations and the ESG indices may underperform. Technology, which accounts for between 27% to 31% of many ESG indices (vs. the benchmark weight at about 27%), already has a stretched valuation. The sector currently has a PE of over 28; and the last time it was higher than 25 was prior to the Great Financial Crisis.

With regard to single stock valuation risk, Amazon is trading at a PE of 91 which, admittedly, has come down from the last few years but is still very high and this could influence returns (see Stock Skews).

Conclusion

At The Index Standard, we like what the ESG concept advocates and EGS investing is becoming an effective way to steer the boardroom’s attention towards worthy causes beyond chasing revenues. Nevertheless, not all ESG indices are created the same and the short track record of the concept makes it even harder for our readers to pick good products.  We hope the new rules in this guide help, and we are hopeful that more academic research and more collaboration between the index providers will offer a more transparent and investor-friendly landscape in the near future.

References:

  1. CNBC “ESG sees record inflows amid pandemic. One leading issuer on the theme’s staying power.” Sept 19, 2020
  2. ETF Express. Beyond Beta. The ‘myths’ around indexing and ESG. November 2020.

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