It sounds like an unbeatable deal for investors: a way to not only grow wealth but to do so with better performance than the overall market and while acting in concert with their moral values.
This is the promise of sustainable investing, one of the trendiest strategies on Wall Street, but one where the effectiveness remains highly debated and skepticism about long-term performance is preventing even more broad-based adoption.
Generally speaking, sustainable investment strategies screen securities across a variety of metrics, tilting a portfolio to the ones with the best scores on environment, social and governance (ESG) issues. Proponents argue that the stocks or bonds with higher ESG scores will also see better long-term performance relative to benchmark indexes like the S&P 500 SPX, -0.63% .
A number of major investment firms have launched ESG products of late, focusing on such ideas as gender diversity, low carbon emissions and portfolios that exclude gun-related stocks.
Investors have also taken to the idea. According to Morningstar, sustainable funds averaged $924 million in monthly inflows in the first five months of the year, a pace that’s nearly twice the 2017 average of $532 million. Flows into such products have accelerated since the 2016 election, a trend that analysts credited to President Donald Trump, whose administration is seen as hostile to environmentally friendly policies, spurring investors to seek a counterbalance.
In the first half of 2018, 28 existing funds (both mutual funds and exchange-traded funds) added impact criteria to their investment processes, while another 13 explicitly ESG funds were launched, bringing the total number of sustainable funds to 285, Morningstar calculated.
Notably, the Goldman Sachs JUST U.S. Large Cap Equity ETF JUST, -0.68% debuted in mid-June and garnered $251 million in assets in its first day of trading. According to the firm, this made it one of the top 10 equity ETF launches in history, although the fund’s popularity is likely due to Goldman’s distribution muscle as much as investors taking to the strategy, which favors companies engaged in “just business behavior.”
According to a survey by the Morgan Stanley institute for sustainable investing, 84% of global asset managers are pursuing or considering ESG investments. That interest, however, belies a certain amount of skepticism about whether ESG strategies add value compared with simply investing in the market through an index-based product. The survey showed that when it came to the biggest challenge facing broader ESG adoption, 23% of respondents named the quality of ESG and sustainability-related data, while another 24% cited “proof of market-rate financial performance.”
According to a survey of financial advisors conducted by Cerulli Associates, only 19% of the advisers who use ESG products cite the strategy’s returns as the major factor behind their adoption. Meanwhile, 35% of respondents said concerns over negative performance was a significant factor keeping them from such strategies.
Confusing the issue is that how a company scores on ESG metrics can vary wildly depending on who is doing the scoring. Different analysts look at different factors, favor different qualities over others, and otherwise lack consistency from ratings firm to ratings firm.
“One specific challenge is a lack of standardization — every ratings system prioritizes different factors when defining a ‘good’ ESG company,” wrote Emily Dwyer, a research analyst focusing on ESG issues at Brown Advisory. “Some prioritize transparency and disclosure; others prioritize a company’s environmental or social track record or its past controversies; others prioritize current carbon emissions. Depending on which ratings service you choose, you may see wildly different results.”
Per Brown’s analysis, there is a wide gap in how different rating firms evaluate the same stocks, as seen in the following chart.
In one extreme example, American Tower AMT, -0.63% received a top rating from one ratings system and a “rock-bottom rating” from another. The former cited how the cellular tower company treats its workers while the latter criticized its lack of transparency and disclosures.
“The key question here shouldn’t be which rating is correct — each firm’s analysis raises good points. Instead, investors should ask what they can learn from each of these ratings, to help them build a more complete picture,” Dwyer wrote.
Because of the differences in how ESG scores are tallied, data concerning the effectiveness of ESG issues is similarly mixed.
“We have found that traditional ESG scores are composed of a large number of issues that are not material for every industry or company. Specifically, for two-thirds of all securities in the Russell Global Large Cap Index universe, less than 25% of the data items in the traditional score are considered material,” wrote analysts Russell Investments in a report published at Harvard.
The report, building on previous research, found that investing around material ESG issues can lead to better performance, while “investment in immaterial sustainability issues does not lead to better financial performance, and may in fact detract from performance.” As an example, it cited fuel efficiency, a key issue for transportation companies, but not a primary concern for investment banks.
MSCI suggested that ESG scoring could be a way to augment the analysis of a company beyond more traditional financial metrics, writing that it can “help sort the truly outstanding firms from a group that already shares an array of robust financial traits.”
According to Panos Seretis, MSCI’s executive director of ESG research, “When it came to a select group of companies with excellent financial fundamentals, ESG information was more than just a proxy for strong governance. Better management of environmental and social risks and opportunities led to higher MSCI ESG Ratings, which, in turn, were associated with higher return on invested capital and valuation. In short, environmental and social scores provided an overlay investors may use to further differentiate performers.”
TruValue Labs, which conducts its own ESG analyses on companies, said that traditional ESG signals “suffer from numerous hurdles,” including the fact that ESG data is often sourced from the companies themselves, which can lead to incomplete data sets as different firms have different disclosures policies. It added that much of the data that is disclosed is often a year old.
In a report touting its own scoring process, however, it wrote that “Companies with strong information flow, good overall ESG scores and positive ESG momentum outperform the S&P 500 and Russell 1000 benchmarks over a 10-year period, adding about 3% to 5% of alpha annually.”
One of the most popular broad-based ESG products is the iShares MSCI USA ESG Select ETF SUSA, -0.66% which has about $730 million in assets. It is up about 11.2% over the past 12 months, below the 13.8% gain of the S&P 500 over the same period.
Another sizable fund is the SPDR SSGA Gender Diversity Index ETF SHE, -0.24% , which holds stocks that have higher percentages of women in senior positions. While data have suggested that gender diversity can contribute to better long-term performance, this fund has lagged as well, up 9.5% over the past 12 months.
Original Article found here.