By Jeffrey Haindl, CFA®, CFP®

This year, ESG (Environmental, Social and Governance) strategies have outperformed traditional portfolios. This is partially attributed to the outperformance of technology and the underperformance of the commodities sector during the ongoing COVID-19 crisis.

Within different business sectors, companies have emerged as ESG leaders for having made strides to better understand the sustainability of their business models. These companies were likely better prepared to cope with the pandemic by incorporating ESG factors into corporate decision making; they encouraged management to take a longer-term view of their business model than just focusing on short-term profitability and its impact on share price and stocks awards.

Despite existing shortcomings in their current evaluation methodologies, I strongly believe that ESG factors should be taken into consideration when making investments decisions.

At Swiss American Wealth Advisors, it is important for many of our clients to align their investment choices with their personal values. In addition, our clientele is international and needs investment solutions that are compliant and effective in and across multiple jurisdictions. That is why we focus on using low cost and tax efficient exchange traded funds (ETFs) to build diversified portfolios. Fortunately, the ETF industry has reached a level of maturity that allows us to build compelling ESG ETF portfolios.

In light of the growing adoption of ESG reporting, efforts to standardize methodologies and disclosures, and increased investor demand, we are excited about the prospects of ESG investing.

Emergence of ESG        

ESG investing has come a long way since the ’90s when I was studying economics with a focus on environmental economics and public choice at the University of Zurich in Switzerland.

Back then, the focus was on negative environmental impacts. Some of us still remember the images of the oil-covered animals from the devastating Exxon Valdez oil spill in 1989, or the Antarctic ozone hole and the treaty to phase out chlorofluorocarbons (CFCs) the same year.

The protection of our environment was a big topic in those days—not unlike today. That’s when a number of investment houses that focused on sustainable investing started to emerge.

This development was particularly pronounced in Europe, where investors have led their U.S. counterparts in ESG adoption. The reasons are manifold, but we saw a lot of early institutional demand for sustainable investments in Europe, mostly by pension funds. In the United States, demand for ESG investments among pensions fund managers was less pronounced, but over the last couple of years, we have experienced a surge in interest in ESG investing particularly from individual investors.

It was only in the summer 2018, when the first U.S. ESG ETF met the investment criteria that I felt would be on par or superior to its non-ESG counterparts. These criteria include reasonable costs, good trading volume with tight bid-ask spreads, tax efficiency, a first-class investment manager and a sizable, growing asset base.

Interestingly, this instrument was not a U.S. focused ETF, but an emerging market ETF managed by BlackRock, the Ishares Emerging Market ESG ETF (ESGE).

My investment rationale, other than efficiently getting diversified exposure to emerging market equities, was not necessarily driven by environmental but governance considerations.

Good governance plays a crucial role in markets that are less stringently regulated than U.S. markets, especially when it relates to controlling and mitigating company specific risks.

I felt so strongly about the advantages of ESGE and started using it in our traditional ETF portfolios.

Universe of ESG ETFs

The universe of ESG ETFs has grown significantly, allowing us at Swiss American Wealth Advisors to build most of the equity exposure in client portfolios with ESG ETFs. More recently, bond ESG ETFs have also gained traction and we have started to use some of them as well.

Early ESG ETFs were often “exclusion based” with most providers excluding companies with ties to nuclear weapons, producers of firearms, companies that violate the UN Global Compact, and thermal coal, oils sands and tobacco companies from their ESG ETFs.

In addition to exclusion-based ETFs, investors can now choose from a variety of thematic and impact investing ETFs that focus on a particular theme or aim to have a positive impact by promoting positive and limiting negative externalities.

Examples include ETFs that invest in companies that benefit from the transition to a low-carbon economy or impact investing ETFs that have a positive impact on society such as fighting poverty, hunger, promoting health, education and gender equality—just to name the first five of the 17 sustainable development goals of the United Nations.

Challenge: Data Quality and Consistency

The biggest challenge for ESG investors has been data quality. This is not surprising as the majority of ESG reporting by companies has been voluntary.

There are many different ESG rating agencies such as MSCI, Sustainalytics, RobeccoSAM, FTSE Russell, Vigeo Eiris, which is majority-owned by Moody’s, or Oekom, which belongs to ISS. However, unlike the credit rating of corporate bonds, which is fairly consistent across the major credit rating agencies, the ESG score across providers can vary dramatically.

In the MIT Sloan Research Paper “Aggregate Confusion: The Divergence of ESG Ratings,” the correlation between the rating of various ESG rating agencies was on average 0.61 while credit ratings from Moody’s and Standard & Poor’s are correlated at 0.994.

The reason for the difference ratings boils down to data quality and the lack of globally accepted reporting standards.

I doubt we will ever see a 99% correlation among ratings of different rating agencies, but gaps are expected to narrow as data quality continues to improve and as companies face further pressure from investors, regulators and legislators for ESG disclosures.

It is precisely the availability of consistent and accurate data that will allow index and ETF providers to make the next step from exclusion-based products to ESG products that integrate ESG ratings in the company selection process.

Without a doubt, a lot has changed in the world of ESG since my days of studying public choice, the application of economic tools to traditional problems of political science. Not to mention in just the past few years ESGE went from $97 million in assets at the end of August 2017 to more than $5 billion today. By the looks of things, the journey has just begun.

Jeffrey Haindl, CFA®, CFP® is an Investment Advisor Representative with Dynamic Wealth Advisors dba Swiss American Wealth Advisors. All investment advisory services are offered through Dynamic Wealth Advisors.

Photo credit: Michael Behrens, Unsplash