How is the landscape of ESG investing changing within ETFs? Are we still excited by it, or is enthusiasm dwindling. Jordan Farris, Head of ETF Producer Development at Nuveen examines the case.
The term “ESG” continues to be a hot button topic of conversation within the investing community, and few acronyms have been used more frequently over the past year. ESG-branded products have grown quickly in number and size, but we sometimes find that education about the space has lagged compared to the number of headlines.
But when we hear ESG, what exactly comes to mind? Is it responsible investing? Is it underperformance? Is it climate change?
How ESG definitions help us
“ESG” refers to a set of environmental, social and governance factors that serve as an additional set of inputs for security analysis. These factors may help identify business model risks that are not as visible through traditional methods of fundamental analysis.
For example, within the environmental category, companies can be evaluated in areas such as water stress, toxic waste management, carbon footprint management, and raw material sourcing. Social factors may consist of human capital development, worker health and safety, privacy and data security and supply chain labor standards.
Lastly, the governance criteria may include executive compensation disclosure policies, board diversity, and business ethics policies designed to mitigate bribery and corruption.
Combining various factors within each of the E, S and G pillars ultimately produces a numerical score that measures companies relative to industry peers.
This process has helped to identify and avoid numerous companies that have experienced major breakdowns within their business models and have subsequently experienced precipitous declines in their stock prices. As many of us know, avoiding losers can be as beneficial as picking winners – and ESG integration can support this.
But don't call ESG, SRI!
It is important to note though that ESG investing is different from “socially responsible investing” – or SRI, which first caught investor interest several decades ago. The key difference being that socially responsible investing uses an exclusionary-only approach, in which an asset manager identifies areas of the market that generate revenue from industries in conflict with certain societal values.
Common examples of these areas include tobacco and alcohol producers, weapons manufacturers, or casino operators. It was a simplistic approach whereby an asset manager would select the controversial business area it wished to avoid and thus remove it from the eligible universe of investments.
However, an issue with this approach was that it led to sector imbalances and increased tracking error relative to traditional benchmarks, and in some cases, resulted in underperformance.
We believe that individuals should not have to sacrifice performance in order to align their investments with their personal values.
While a significant evolution has already taken place within ESG Investing, there is still more to come for the industry. Alongside the rise of big data, we have witnessed the growth of ESG data vendors – firms that commit significant resources to collecting and analyzing vast amounts of records linked to ESG factors.
Data sources include regulatory filings and mandatory disclosure documents, government and NGO datasets, and various media outlets. Advancements in data and technology will play a critical role in realizing the true potential of ESG investing.
How ESG factors are applied to investing
At Nuveen, the increase in consumable ESG data, including the number of securities covered by ESG data vendors, allows us to apply a consistent set of environmental, social and governance factors across our entire product set which increases the ESG rating, reduces the carbon footprint, and seeks to provide the risk and return characteristics of traditional benchmarks.
As opposed to simply excluding specific areas of the market, we maintain broad sector diversification by evaluating companies against their sector and industry peers. Those companies identified as ESG leaders within their respective industries remain eligible for investment while those who fall behind are removed.
We believe that individuals should not have to sacrifice performance in order to align their investments with their personal values. As societal values evolve and industry stakeholders demand greater transparency, innovative product development is paramount to aligning investor values with investment returns.
The ETF industry is no exception, and the ESG trend will continue to drive new and unique strategies as we enter the next decade.
Jordan Farris will continue this discussion on ESG in ETFs at Inside ETFs in Florida later this month. He will discuss a modern day approach to managing risk in ESG.
