Calling For Standards And Clear Definitions In An Industry Of Murky Algorithms

|
Includes: ESG, SPY, SUSA, VOO
by: Clemens Kownatzki
Summary

MSCI estimates that the millennial generation could invest somewhere between $15 trillion and $20 trillion into U.S. based ESG investments in the next two to three decades.

But “ESG” doesn’t mean the same thing among different ETF issuers. The criteria are quite often veiled in prospectus filled with legalese and financial lingo.

Judging the "goodness" of an ETF by examining its holdings may be your best gauge of whether to invest in ESG funds or not.

The growth of theme- and values-based investing in the past few years has been spectacular. The Global Sustainable Investment Alliance reports that sustainable investing assets stood at over $30 trillion globally at the beginning of 2018.

Part of this fascinating growth story has to do with the phenomenal success of Exchange Traded Funds (ETFs) that outpaced traditional Mutual Funds in terms of asset growth for over a decade now. Lower fees and the ability to trade ETFs during market hours just like stocks have made ETFs a more attractive proposition especially for average investors hoping to gain exposure to the major market indexes.

ESG investing, which includes environmental (NYSE:E), social (NYSE:S), and governance (NYSE:G) factors, is based on the notion that companies incorporating these non-financial measures in their decision-making process are more sustainable and therefore present better long-term prospects. ESG and other sustainability themes resonate a lot more with the new generation of millennial investors.

To that end, MSCI estimates that the millennial generation could invest somewhere between $15 trillion and $20 trillion into U.S. based ESG investments in the next two to three decades.

When so many acronyms are entering the mix of investment decision criteria, things can get a bit confusing for average investors. More perplexing still is the number of competing ETF issuers with similar themes resulting in a plethora of theme-based ETFs.

ETFdb.com lists 401 SRI funds in their database and that list includes leveraged and inverse ETFs - I kid you not. For instance, they show ProShares UltraShort S&P 500 on that list. Why a leveraged-inverse ETF, which is essentially a highly complex derivative, could be considered socially responsible is unclear.

A smaller list of only 86 socially responsible ETFs is available on ETF.com. Interesting to note here are the many “ESG” titled funds. Why are they included in SRI and what’s the difference anyway one might ask?

The same site lists 50 ESG funds. Fascinating here is the fact that entire country ETFs are labelled with an “ESG sticker.” Norway, Denmark, Netherlands, Austria, Switzerland, and Portugal are all included in that list. Since these country ETFs are representative of their respective total market, one must ask: Are there no “ESG-controversial” companies in these countries? Are these European companies all goody-two shoes?

While we cannot blame the ETF issuers nor the Index providers for ending up in a perhaps misguided list of ESG funds, we must still ask how there are so many similar and often competing ETFs - what’s the catch?

More importantly, “ESG” doesn’t mean the same thing amongst different ETF issuers. The criteria are quite often veiled in prospectus filled with legalese and financial lingo - a turn-off to any investor. So what’s an investor to do? How to choose among all these enticing options when we only have limited time and equally limited funds for investment research?

I often compare investment choices with the product selection in super markets. The multitude of choices are similarly confusing for an average shopper. However, when I shop in the organic foods section, we can and should expect that all products in that section are there because they adhere to certain standards and I can be reasonably sure that my lettuce isn’t farmed next to a nuclear power plant and free of carcinogens.

While we cannot expect to have clearly defined metrics of these theme-based ETFs anytime soon, the next-best alternative is to look at their holdings and then decide whether the chosen companies meet our own personal definition of environmental, social, and governance factors.

That said, let’s look at one of the ESG funds and let me apologize in advance here. I am not trying to pick on this particular fund but given the “ESG” ticker symbol for the FlexShares STOXX® US ESG Impact Index Fund, this seemed like an easy choice: FlexShares STOXX® US ESG Impact Index Fund - ESG ETF

According to their website:

“The Fund seeks investment results that correspond generally to the price and yield performance, before fees and expenses, of the STOXX® USA ESG Impact IndexSM (Underlying Index).

1. Track STOXX® index designed to serve as a core equity holding with Environmental, Social and Governance (ESG) exposure in an effort to enhance risk adjusted returns

2. Index assesses US companies based on Key Performance Indicators (KPIs) in ESG categories

3. Index aggregates criteria into one score and "tilts" the portfolio to companies with the highest scores

4. Constraints are utilized in an effort to minimize overall risk within the strategy

This ETF currently holds 282 stocks and their Top Ten Holdings include the following companies:

Holdings as of August 21, 2019 Source: FlexShares STOXX® US ESG Impact Index Fund - ESG ETF

We all have our own perception of what companies stand for but it seems of peculiar interest how some of these companies ended up in their top ten holdings. Would you associate a company like Exxon Mobile with positive environmental factors?

Speaking of which, the following oil/energy companies are also part of this ETF.

Holdings as of August 21, 2019 Source: FlexShares STOXX® US ESG Impact Index Fund - ESG ETF

You can use your moral judgment as to whether you feel these companies can be associated with positive ESG factors irrespective of what the index’s or ETF issuers’ quantitative metrics might suggest.

If you’re still sitting on the fence, I would suggest you go one step further and see how this ETF compares with your standard low-cost index fund e.g. the SPDR S&P 500 ETF. You can use any of the financial sites to run a quick visual test. The chart below compares our chosen fund ESG with SPY as a proxy for the major US market index. Visual inspection suggests a high correlation between the two.

Source: TradingView

Using a more quantitative approach, we find that the correlation of daily returns between ESG and SPY since January 2019 was 99.1%.

I have noticed similar high correlations among other ESG funds. For instance, iShares MSCI USA ESG Select ETF (SUSA) has a very high correlation with the market as well (see chart below).

Source: ETFreplay.com

Why is this important?

If you invest in a financial instrument that comes with a certain label of goodness while it resembles the general market to a large extent, you may not be getting what you had hoped for. If you then pay higher fees for the privilege of investing in “noble businesses”, it becomes all the more problematic.

The fees for SUSA are 0.25%, more than double of SPY’s 0.0945% and eight times more than Vanguard’s S&P 500 ETF (VOO) expense ratio of 0.03%. Turning back to our original fund ESG, it has an expense ratio of 0.32%, about 10 times that of the Vanguard SPY 500 fund. These are not the most expensive ETFs though. There are ESG-type ETFs with expense ratios of nearly 1% while the average cost of the 50 listed ESG funds on etf.com is currently 0.41%.

In closing, I’d like to emphasize that I am not blaming an industry for taking advantage of what seems to be a growing investor sentiment towards social good. However, as an investor you should be aware of what you invest in and decide whether the output of an algorithm meets with your definition of goodness. It also brings up the important question of ethics. Is it ethical to put a label of goodness in the form of “ESG” or “SRI” on an investment vehicle when the ethics of some of the companies held are questionable at best?

In terms of investing with your conscience, might I suggest that you maximize your returns and pick a low cost index fund while investing with your conscience privately through your preferred charitable organizations.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.