Investors Are Starting to See the Positive Effect of ESG Investing

Screening methods may uncover alpha in small caps.

As the tide pulls some chief investment officers and asset owners toward improving corporate environmental, social, and governance (ESG) practices, there is strong evidence that ESG investing is now rewarded, especially in the Eurozone, according to a recent Amundi SA study. Investors are starting to see the positive effects of ESG investing on their returns.

Companies with high ESG scores in the Eurozone generated annualized returns of 6.6% from 2014-2017, compared to an annualized loss of 1.2% three years earlier.  ESG investing in North America also saw positive returns, as top-rated ESG companies produced annualized returns of 3.3% during the same timeframe.

Until 2014, ESG best-in-class strategies provided neutral or slightly negative results, but when the study focused on shorter periods, it showed a positive selection effect on highly rated companies, sometimes combined with the underperformance of poorly rated stocks.   According to the study, “The Eurozone and North America are particularly responsive to ESG integration, with a higher reward for governance and environmental pillars, respectively. Social began to be rewarded in 2016, and since then it is catching up.”

Martin Kremenstein, head of ETFs at Nuveen asset management ($970 billion assets under management), has also seen this surge, especially with small caps, “since quality is a key factor in deriving alpha.” 

In 2016, Nuveen launched ESG large cap value, large cap growth, midcap value, midcap growth, and small caps in the domestic space, and followed up with developed markets, emerging markets, and a core fixed income product in 2017.

Kremenstein is finding, “The alpha effect of ESG seems to be more cyclical in growth, but it seems to be consistent in value and small caps,” with his Nuveen ESG Small-Cap ETF (NUSC) in the top 6% of small cap core funds in Morningstar for the two years since launch.

For 2018, Nushares ESG Large-Cap Growth ETF (NULG) outperformed the Russell 1000 Growth by 230 basis points. The NUSC outperformed Russell 2000 by 174 basis points and the large cap actually outperformed by 395 basis points.

Screening Tricks

The trick is to start by ordering investments by sector, doing a controversy business screening (involvement in alcohol, tobacco, and firearms, etc.), scoring for the ESG material factors for that industry, applying the carbon screen, and finally optimizing weights, he says.

Ordering companies by sector ensures, for example, that Schlumberger is being compared with Valero. Facebook would be compared to Adobe and Microsoft (the latter two scored pretty well) and each would be given an ESG ranking relative to that sector.

During the second round, a company’s past response to controversy is assessed.

“A CEO’s misbehavior is one thing; a CEO’s misbehavior that reveals endemic structural and governance issues with the company is a much more significant event,” says Kremenstein.

Next, he scores companies on absolute carbon emissions, potential carbon emissions, and removes any with fossil fuel reserves. He then optimizes the weights of the sectors back to within 4% of the base non-ESG index, with 8% being the band for energy.

If this ESG screen was used to invest,  the tanking of Equifax was likely missed because it revealed it wasn’t fixing the mounting problem that caused an earlier data breach in 2016 (of 430,000 names) before the big breach in 2017 (that could amount to 143 million Americans affected.) This same screen showed the waxing and waning of a Facebook investment due to the way it violated its privacy policies early on.

It begs the question: Shouldn’t investors know the ESG score of every company in their portfolios?

“There’s value that’s generated by employing the ESG metrics, because you’re essentially removing companies that have poor pollution and poor material resource management, companies that are wasteful, companies that have bad relationships with their investors, with their employees, and with regulators, and companies that have bad governance structures,” said Kremenstein.

Tags: , , ,