One big political debate these days is about whether ESG investing is a winner or not. Several red states have banned the strategy from their pension funds, arguing that nonfinancial considerations should have no bearing on investment decisions.
Actually, Research Affiliates, the asset manager and research firm, contends that portfolios that stress environmental, social and governance precepts do not fare significantly better or worse than non-ESG investments—if both are weighted by market capitalization, which is the standard practice in finance.
Research Affiliates’ report, by Brent Ledbetter, head of equity solution distribution, and Ari Polychronopoulos, head of product management and ESG, compared the Russell 1000 Index (which ranks stocks by market cap) with the six largest ESG exchange-traded funds, which also are cap-weighted. Over the past four years—some of the ETFs are relatively new, so the timespan was chosen to include them—the ETFs and the index all tracked each other closely.
Part of that may be because the ESG funds and the Russell 1000 all hold the same stocks in their top 10, with Big Tech a common theme: Apple, Microsoft, Alphabet, etc. “The comparison of these five largest ESG investment vehicles to a non-ESG cap-weighted benchmark reveals essentially no differences among the portfolios because the five products each weight their holdings by market capitalization,” the report stated.
Ledbetter and Polychronopoulos argued that investors can score better performances than the index by avoiding cap-weighting and employing fundamental factors: price to sales, price to cash flow, price to earnings, price to book and price to dividends. Using these approaches for ESG investments makes the resulting portfolio cheaper and, for the most part, it delivers better returns than the cap-weighted Russell 1000 Index, they found.
To be sure, this fundamental factor method is the favored allocation of Research Affiliates. The duo compared their firm’s RAFI ESG U.S. index (RAFI stands for Research Affiliates Fundamental Index) with the Russell 1000 benchmark. The RAFI portfolio’s top holdings included some Big Tech stocks, but a lot more from beyond that sector than in the Russell allocation.
Are the two strategists talking their firm’s book? Yes.
But they make a point. The RAFI alternative is less expensive: It traded at a 39% discount to the Russell index and has a value tilt, with components such as Citigroup, at a low 6 P/E. The cap-weighted ETFs traded at a 10% premium to the Russell.
Meanwhile, “the RAFI ESG Index provides a reduction in carbon footprint close to that of the five largest US cap-weighted ESG products we analyze,” the Research Affiliates paper said. That makes sense. Whether their leading holdings are tech or financials, they are hardly polluting industries.
The RAFI ESG portfolio outpaced the Russell 1000 from 2020 through mid-2021, and then the Russell index did best for the last half of 2021. While the period covered is admittedly a short timeframe, it seems to show that coupling fundamental factors and ESG could indeed be a winner.
In the view of the report, “cap-weighting is not the only form of indexing available to ESG investors. Those investors who want to incorporate their ESG preferences in their portfolios can opt for alternative forms of indexing.”
19 Republican States Create Anti-ESG Alliance
DOL Offers First Legal Defense of Its New ESG Rule
UK Pension Regulator Targets Plans for Climate, ESG Non-Compliance
Tags: cap-weighted, ESG, ETFs, fundamental factors, RAFI ESG portfolio, Research Affiliates