ESG investing considers Environmental, Social & Governance factors as part of the investment decision. Some ETFs choose their companies based on their own research, and some follow a social responsibility index like MSCI KLD 400 Social Index. The index weighs 400 US companies based on capitalization and excludes companies that have low ESG ratings. Obviously, the index doesn’t just take into account good ESG performance but also takes into account the following factors. Sounds interesting, but what’s ESG fund performance vs. non-ESG is like? Are ESG funds worth it?
Top ESG ETFs
I will start by looking at some of the most popular ESG ETFs on the market today and compare their performance, composition, fees & risk profile. To keep it diverse, I will look at three general market ETFs and two energy-focused ETFs.
iShares MSCI USA ESG Select ETF
Vanguard ESG U.S Stock ETF
iShares ESG Aware MSCI EM ETF
iShares Global Clean Energy ETF
Invesco Solar ETF
Let’s jump straight into backtesting.
SUSA vs. SPY
SUSA’s objective:
The iShares MSCI USA ESG Select ETF seeks to track the investment results of an index composed of U.S. companies that have positive environmental, social and governance characteristics as identified by the index provider.”
Let’s compare a hypothetical $10,000 investment in iShares MSCI USA ESG Select ETF – SUSA and compare it S&P500 ETF – SPY.
Interestingly, SUSA mirrors the performance of SPY almost perfectly. Here are the Top 10 Holdings of SUSA compared to Top 10 Holdings for SPY.
SPY
SUSA
Aha, that is quite an overlap, especially in the technology sector. SUSA is capitalization-weighted ETF (How to understand ETF weighting methodologies?), so it is heavily weighted in the biggest stocks, which in today’s market, are technology stocks.
SUSA only has 200 holdings compared to 508 of SPY, but the exclusion of that many companies doesn’t impact the performance. That is the downside of top-heavy ETFs like that. A few key companies drive the majority of results. The Information Technology sector represents almost 30% of all holdings.
SUSA follows the MSCI ESG index and doing that is more expensive so it would make senes if SUSA will have a higher Management Expense Ratio (MER) and it does.
Is SUSA a good buy today?
So what are we getting with this ETF? We get performance that is very close to that of S&P500 but is more ESG focused. You will also give up 0.16% of your return to fees compared to SPY. Just like SPY, SUSA is exposed to the technology sector quite a bit, so by investing in it today; you have to be bullish on the tech sector in general.
What are analysts saying about tech stocks?
At the time of writing this in August of 2021, analysts remain Very Bullish on top technology stocks and expect the sector to grow.
Read Related:Is tech overvalued? In 2021
ESGV vs. SPY
Vanguard’s ESG fund doesn’t have enough history to successfully backtest. We can only compare the last few years.
Very short period to make any decisive conclusions, but the ETF mimics SPY very closely. Here is a look at monthly performance.
How can that be? Well, it is the same story as with SUSA. Cap-weighted ETFs from U.S will all have very heavy technology stock weighting. Here is the Top 10 for ESGV.
Ah, looks familiar. It is the same stocks all over again. The technology sector represents over 30% of ESGV, so keep that in mind if you decide to buy it.
ESGV is quite cheap at 0.12% compared to SUSA 0.25%.
Notable difference is that Vanguard’s ESGV is a massive ETF with over 1200 holdings. It doesn’t follow the MSCI rigorous guidelines of what ESG means. Vanguard’s strategy here is to follow the FTSE US All Cap Index with companies being excluded from the list.
Specifically excludes stocks of certain companies in the following industries: adult entertainment, alcohol, tobacco, weapons, fossil fuels, gambling, and nuclear power.
Is ESGV a good buy today?
Compared to SUSA, ESGV is a lot more diversified with over 1200 holdings, but at the same time, it is 30% in technology stocks. When one sector is so heavily dominant in the ETF, we should ask ourselves what the future prospects of that sector are.
So far in 2021, technology stocks have been performing very well. Coronavirus made a lot of tech-related services more in demand, and the earnings reflected that very well; just look at the most popular stock’s Earnings per share growth over the last year.
Is this growth sustainable, and will it continue in the future? Hard to say, but top analysts across the internet & Wall Street all remain very bullish on the sector.
There isn’t much historical information, but it looks like the two funds track each other almost perfectly. It makes me wonder if there is much difference in holdings between ESG and non-ESG Emerging Market ETFs.
VWO is a massive ETF with over 4200 holdings compared to ESGE of only 344. Yet the there is significant overlap in top holdings for both ETFs, specifically Taiwan Semiconductors, Tencent & Alibaba, making up around 15% of the ETF.
Fees
ESGE is slightly more expensive, but looking at the concentration of assets, slightly better historical performance, and similarity to VWO, but with the ESG aspect, ESGE might be worth it. Especially for somebody looking to expand into emerging markets but doing so with ESG in mind.
Clean Energy
How clean is “clean” energy remains a debate. Once scientists study an energy source in more depth, they uncover new ways that it has negative impact on ESG.
We will ignore that aspect for this analysis and purely focus on financial performance. The argument made boy the industry is that over the long-term, clean and sustainable energy will outperform, so perhaps, it doesn’t make sense to do historical backtesting here. However, as I often say, history is not meaningless and can at least provide us with somewhat realistic expectations for the future.
ICLN vs XLE
iShares Global Clean Energy ETF vs. Energy Select Sector SPDR Fund
Hypothetical $10,000 investment in both funds made in 2008, yield quite poor results for both funds. XLE has consistently outperformed ICLN throughout most of its history until a massive drop in 2019.
At the same time that is exactly when clean energy starting to pick up speed. Looking at the chart, it looks like the two ETFs are perfectly negatively correlated.
Why is that?
Let’s take a look at XLE’s top 10 holdings.
Okay, that makes it very clear. Buying XLE is buying top oil companies so it would make sense for the price of XLE to fluctuate in sync with oil prices.
Here is the Average Crude Oil Spot Price plotted against XLE.
XLE is an incredibly top-heavy ETF which is another downside. 50% of the ETF are 3 Oil companies. If I were to invest in oil, I would research those companies separately and consider investing but not through an ETF.
Past Performance Not Guarantee of Future Results
I believe that is definitely going to be the case with clean energy. ICLN has underperformed for a 10 year period compared to oil, until recently. Will that trend continue?
Oil is not going away any time soon but the growth of renewable energy sources is growing at incredible pace across the globe.
Renewable energy is the fastest-growing energy source in the United States, increasing 100 percent from 2000 to 2018.
Renewables made up 26.2 percent of global electricity generation in 2018. That’s expected to rise to 45 percent by 2040. Most of the increase will likely come from solar, wind, and hydropower.
Investment in clean energy ETFs like ICLN is a long-term investment. You will have to wait for more people and countries to adopt new technologies into their core infrastructures. That takes time and money. ICLN is not U.S focused which we can view as a positive or a negative, depending on your strategy. International exposure is great for diversification. Also if we consider how well the oil industry protects itself in the United States, the move to other energy sources might happen in other countries quicker than in the United States.
Renewable energy starts to make more and more economic sense. A positive trend in the industry is that these energy sources are becoming cheaper and cheaper.
The cost of large-scale solar projects has plunged 85% in a decade.
This is fuelling the rise of renewables as the world’s cheapest power.
While scientist debate whether these sources are actually benefiting the planet, economics start to make more sense. This alone is encouraging that the growth will continue. We are in the early days still so technology will only improve. So while the performance hasn’t been phenomenal in the past, I do see the future being different.
Solar ETFs
Solar is the subset of the renewable energy sector. As of 2020, Solar represents just 1.32% of U.S energy consumption by energy source.
That said, the industry is seeing growth as the prices of solar continue to decline.
Invesco’s Solar ETF – TAN is the biggest ETF focusing specifically on solar companies. ETF does suffer from top-heavy concentration, but at the same time, it is a very specialized ETF, so it makes sense that there aren’t too many big solar companies to provide ample diversification.
TAN vs ICLN
I want to compare a hypothetical $10,000 investment in Invesco’s Solar ETF – TAN vs Shares Clean Energy ETF – ICLN. We know that generally ICLN had really poor performance over the last 10 years until 2020 where it took off so I expect the same result for TAN.
Results are as expected with ICLN slightly doing better than TAN.
Fees
TAN is also slightly more expensive with an Expense Ratio of 0.69% compared to 0.46% for ICLN.
Unless you are specifically looking to invest in Solar, at this point in time, I would pick ICLN over TAN. You get a better-diversified ETF with exposure to Solar energy but also other clean technologies. It is slightly cheaper and has historically performed better.
ESG Funds perform better over the long run
The reason I wanted to break down the whole ESG fund sector into individual funds is because I often hear a claim that ESG funds tend to perform better. However, markets are not that binary. Yes, some clean technologies have delivered impeccable results but others have not. Not all ESG-friendly companies are made the same. Stock market is a market of individual stocks, we must remember that. So when looking for investment opportunities, we need to look at them on individual basis as well as part of their industries, and the world as a whole.
The whole concept of ESG is subjective. MSCI has clearly defined what they call ESG but companies can manipulate metrics that make them more ESG-friendly without necessarily changing how they operate at the core. That is not a bad thing in the end. Companies might start manipulating some of these metrics but over time, hopefully it will be easier to actually implement some of the changes rather than simply virtue signal.
Global ESG funds have underperformed the broader market in the past five years, returning an average of 6.3% per year, compared with 8.9% for broader funds, according to data compiled by Bloomberg.
The evidence on investment returns is more ambiguous — some studies find the stock prices of companies with high ESG ratings outperform, but others find no measurable effects, and some even document lower monetary returns.
ESG information affects Business valuation and performance, both through their systematic risk profile (lower costs of capital and higher valuations) and their idiosyncratic risk profile (higher profitability and lower exposures to tail risk).
ESG funds have even managed to post strong performance during 2020. Of 26 sustainable index funds analyzed by investment research company Morningstar in April, 24 outperformed comparable traditional funds in the first quarter of 2020 (and the beginning of the COVID-19 pandemic).
To begin with, ESG funds certainly perform poorly in financial terms. In a recent Journal of Finance paper, University of Chicago researchers analyzed the Morningstar sustainability ratings of more than 20,000 mutual funds representing over $8 trillion of investor savings.
What is this? This ESG fund performance, as reported by S&P Global, shows that the more a fund is ESG-focused, the higher its financial performance. ESG investing is increasingly becoming a competitive advantage hence the higher ESG outperformance of the market.
Inflation is perhaps the biggest culprit in ESG funds' recently poor performance. U.S. inflation, as measured by the Consumer Price Index, rose at a 7.9% annual pace in February, led by gas, food, and shelter costs, marking another 40-year high.
From our experience and research, ESG links to cash flow in five important ways: (1) facilitating top-line growth, (2) reducing costs, (3) minimizing regulatory and legal interventions, (4) increasing employee productivity, and (5) optimizing investment and capital expenditures (Exhibit 2).
Therefore, ESG stocks tend to be less risky and more effi- cient vehicles for investments. Our model shows evidence that stock performance is closely linked with ESG factors. ESG factors bring lower volatility and therefore lower risk, and consequently higher risk- adjusted returns.
Our results are consistent with those of previous studies regarding control variables (Demers et al., 2021; Broadstock et al., 2021). In summary, our results provide suggestive evidence that firms with high ESG ratings are conducive to mitigating the downside risk of stock prices during the COVID-19 pandemic.
Valuation channel- High ESG rating companies are less vulnerable to systematic market risks such as commodity prices. Lower systematic risk means investors demand a lower required rate of return. This implies a lower cost of capital which translates to a higher valuation.
Even when ESG can be measured, there is no meaningful relationship with financial performance. Accordingly, the responses to ESG critics coalesce on three critical points: the acute reality of externalities, the early success of some organizations, and the improvement of ESG measurements over time.
As Head of ESG Indices Margaret Dorn explains in a blog post, Musks' electric automaker has been removed from the index “due to its low S&P DJI ESG Score”, which reflects Tesla's (lack of) low carbon strategy and (poor) codes of business conduct.
“Retail investors don't understand ESG investing—only 9% say that they have ESG-related investments, and the familiarity with the concept is not as high or as broad as some of the coverage on the topic of ESG investing might suggest,” says Gerri Walsh, president of the FINRA Investor Education Foundation, which ...
Several other studies have shown that SRI mutual funds can not only match traditional mutual funds in performance, but they can sometimes perform better. There is also evidence that SRI funds may be less volatile than traditional funds.
Ratings do not predict returns – or even ESG performance
One study finds that companies in ESG portfolios (those with high Sustainalytics ratings) have worse records for compliance with labor and environmental laws than companies in non-ESG portfolios.
ESG is not going away, however, and the time to deal responsibly and effectively with ESG risk is now. This is especially true as investors are increasingly ready to commit to companies that take ESG seriously.
Findings - The results demonstrate that green mutual funds have generated lower returns and similar risks compared to traditional mutual funds in their respective Morningstar categories. Green mutual funds have underperformed on a risk-adjusted basis.
At the heart of ESG investing is the simple idea that companies are more likely to succeed and deliver strong returns1 if they create value for all their stakeholders – employees, customers, suppliers and wider society including the environment – and not just the company owners.
Increased Productivity - Being sustainable will lead to employees being more motivated to perform better. Sustainability reduces costs and can affect operating profits by up to 60%, according to McKinsey & Company.
Our ESG funds, which have differing investment styles and objectives, invest in stocks and bonds. They're a great way to complement your portfolio with funds that reflect your values.
ESG funds. There are now more than 550 ESG mutual and exchange-traded funds available to U.S. investors — more than double the universe five years ago, according to Morningstar.
There will be more focus on the 'S' in ESG in 2022, following COVID-19 and other significant social campaigns globally, to create a positive workplace culture, but a failure to navigate employee-stakeholder issues may create the risk of employee litigation.
ESG is a framework that helps stakeholders understand how an organization manages risks and opportunities around sustainability issues. ESG has evolved from other historical movements that focused on health and safety issues, pollution reduction, and corporate philanthropy.
CSR focuses on corporate volunteering, lowering carbon footprint, and engaging with charities. ESG provides a more quantitative measure of sustainability. ESG considers environmental, social, and governance factors.
Some of the challenges are as follows: Not all ESG factors are easily quantifiable, and such factors may not directly translate into earnings growth or enhanced performance for the firm. Current corporate sustainability disclosures are heavily skewed towards process and procedures and not towards actual performance.
ESG funds are ETFs and mutual funds that invest specifically in ESG companies. There are a wide variety of ESG funds on the market, and it seems the list grows longer every day. Some ESG funds focus on a specific one of the ESG components: either environmental, social or governance issues.
The acronym ESG, which stands for Environmental, Social, and Governance are metrics used to describe the transparency, sustainability and performance of a company. In other words they measure a company's ability to survive over the long term.
Having an ESG program in place helps boost brand recognition and even promotes brand loyalty. Today's consumers and clients are increasingly aware of ethical spending and care more about what a company does to support sustainability.
ESG and Sustainability have some similarities in that they address the environmental and social aspects. However, there are some differences; while sustainability may mean different things to different entities, ESG is about the specific set of criteria denoting environmental, social, and governance.
Abstract: Recent findings provide evidence that companies highly rated in terms of Environmental, Social, and Governance (ESG) score report higher excess returns and lower volatility, this being supported by the assumption that ESG factors are considered, by market agents, as a good proxy for firms' financial soundness ...
The study found that companies with high ESG scores experienced lower costs of capital, lower equity costs, and lower debt costs compared to companies with poor ESG scores.
Our results do not support previous evidence; the Eurostoxx50 companies' performance does not seem to be affected by their efforts in terms of ESG commitments.
ESG metrics are performance indicators of a business's operations with environmental, social and governance issues to help determine its performance and potential risks. Organizational leaders may integrate principles of these areas into company policies, reports and operations through analyzing or benchmarking.
Sustainable investing at BlackRock. Sustainable investing is the practice of analysing a company's environmental, social and governance (ESG) risks, as well as assessing its opportunities and progress, using ESG data and fundamental insights, to inform the allocation of capital.
ESG ratings are created by both commercial and nonprofit organizations to assess how corporate commitments, performance, business models and structures align with sustainability goals. They are used, first and foremost, by investment firms to screen or assess companies in their various funds and portfolios.
Nearly Half Interested in ESG While Familiarity Remains Low
Currently, 25% of investors, similar to past readings, say they have heard a lot or fair amount about sustainable investing. Ten percent, also consistent with prior measures, say they are currently invested in such funds.
We are pleased to present our annual ESG Report, which discloses how we are addressing the business risks and opportunities presented by key environmental, social and governance issues.
When it comes to an ESG score for individuals, it is about living a sustainable life. ESG scores for individuals may be scoffed at by some, but your individual ESG rating or ESG score meaning for individuals is that you are making an effort to correct what is out of balance.
“ESG is a scam.It has been weaponized by phony social justice warriors,” Musk wrote. In a series of further posts the tech titan shared memes mocking the inclusion of six oil companies on the index, and claiming that a good “ESG score” amounts to a business's compliance with “the leftist agenda.”
Electric-vehicle maker Tesla was recently removed from the S&P 500′s ESG Index. Elon Musk, the Tesla CEO, has described ESG as “a scam” that's been “been weaponized by phony social justice warriors.” Discussions about ESG and goals connected to sustainability have become increasingly charged in recent years.
Apple has been a pioneer in the field of sustainable business practices and environmental, social, and governance (ESG) investing. The company has long been committed to reducing its environmental impact, and it was one of the first to offer products with recyclable materials.
The survey finds that around 85 percent of investors, including 91 percent of institutional investors, consider investment-grade ESG data more important than other company data when informing their investment decisions.
In the United States, fund managers launched 149 mutual funds and ETFs with ESG characteristics or objectives in 2021, comprising about 22% of all fund launches. The one-year growth rate of ESG fund launches in the United States is more than twice that of funds without, 80% versus 34%, respectively.
ESG scores allow investors to gauge the company's intentions actions—from how they treat their employees to how the board decisions are made or if environmental issues are being prioritized.
Increased Productivity - Being sustainable will lead to employees being more motivated to perform better. Sustainability reduces costs and can affect operating profits by up to 60%, according to McKinsey & Company.
The acronym ESG, which stands for Environmental, Social, and Governance are metrics used to describe the transparency, sustainability and performance of a company. In other words they measure a company's ability to survive over the long term.
ESG funds. There are now more than 550 ESG mutual and exchange-traded funds available to U.S. investors — more than double the universe five years ago, according to Morningstar.
ESG funds are portfolios of equities and/or bonds for which environmental, social and governance factors have been integrated into the investment process. This means the equities and bonds contained in the fund have passed stringent tests over how sustainable the company or government is regarding its ESG criteria.
By considering ESG factors, investors gain a more holistic view of the companies they back, which can help mitigate risk and identify opportunities for growth and improvement.
One of the biggest challenges that the companies are committed to sustainability faces are; Operations are impacted the most due to a reduction in procurement. The surrounding community needs to understand the environmental impact of the changes.
You may find it's more expensive to manufacture or distribute your product. You may need to increase the cost of your service. Businesses will need to measure how sustainable they are. This will mean tracking your progress to justify your green ethos.
Inflation is perhaps the biggest culprit in ESG funds' recently poor performance. U.S. inflation, as measured by the Consumer Price Index, rose at a 7.9% annual pace in February, led by gas, food, and shelter costs, marking another 40-year high.
From our experience and research, ESG links to cash flow in five important ways: (1) facilitating top-line growth, (2) reducing costs, (3) minimizing regulatory and legal interventions, (4) increasing employee productivity, and (5) optimizing investment and capital expenditures (Exhibit 2).
ESG investors may require assurances that companies avoid conflicts of interest in their choice of board members and senior executives, don't use political contributions to obtain preferential treatment, or engage in illegal conduct.
With regular broader market index funds or ETFs, the fees are five basis points or 5/100s of a percent — tiny. An ESG fund has a higher fee, maybe around 10 basis points. So it's double but not much overall.
Investments in ESG funds will be taxed as your regular equity investments— long-term capital gains (LTCG) tax at 10% will apply to equity LTCG beyond ₹1 lakh held for more than 12 months and investments held for less than a year will attract short-term capital gains tax of 15% with surcharge and cess extra.
If you're looking for an ESG fund targeting socially responsible behavior and efficient governance, ESGV is one of the best options in the US stock market. It is an index fund by nature and holds around 1,500 stocks with small, mid, and large market caps.
By Evergreen Action and Americans for Financial Reform
In the last few years, “Environmental, Social, and Governance” (ESG) investing has skyrocketed in popularity – in part, fuelled by investors' desire to divest from fossil fuels and put money into more sustainable and climate-friendly funds.
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