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Factors to look for when investing in ESG funds

by Arian Neiron, Managing Director and Head of Asia Pacific, VanEck
Sharesight disclaimer: The below article is for informational purposes only and does not constitute a product recommendation, or taxation or financial advice and should not be relied upon as such. Please consult with your financial adviser or accountant to obtain the correct advice for your situation.

When the Facebook/Cambridge Analytica data scandal broke in March 2018 it was clear that many so-called ‘ESG’ funds were investing in companies that did not share the same values as their investors.

While some scrambled to eliminate Facebook from their portfolio, or justified its inclusion because of its low fossil fuel output, others whose portfolios only target high environmental, social and governance (ESG) performers didn’t have it and were not surprised by the revelations.

Evidence is mounting that companies that adopt ESG factors in their management and operations benefit from improved financial outcomes, largely through risk reduction. VanEck research paper Sustainable Investing: The case for taking a sustainable approach, provides analysis of why investing in companies with high ESG ratings can improve returns for investors, as well as allow them to invest sustainably.

Investing in ESG funds

Essentially, companies with strong ESG profiles typically enjoy enhanced corporate performance and financial returns – and targeting those companies can boost portfolio performance by reducing the risks which companies, and therefore investors, face.

On the other hand, not adhering to ESG factors can greatly cost companies and raise the risks of poor performance. High profile examples including Volkswagen cheating pollution emissions tests highlight where a company’s revenue has been lost due and share price has collapsed due to its misconduct and poor ESG governance.

In their 2015 research paper, Finding Alpha in ESG, Credit Suisse found that integrating ESG factors can enhance portfolio performance both through lower exposure to negative risks related to ESG factors and higher exposure to related opportunities, which can lead to material cost advantages, improved efficiencies and/or new revenue sources.

ESG ratings are, in addition, a possible lead indicator of management quality in that companies which are better managers of ESG factors may also be better managers of shareholder capital, Credit Suisse said.

For investors, adopting ESG requirements in a portfolio can therefore improve performance by helping to minimise exposure to companies with poor ESG performance and thus reduce the risk of their investment not offering sustainable returns.

What to look for in ESG funds

Targeting high ESG performers is just one way to identify true-to-label ESG funds. There are three factors that investors should look for when assessing their ESG fund:

  1. Does the fund target high ESG performers?
  2. What is the carbon footprint?
  3. Does the portfolio include good corporate citizens and can you tell who they are?

ESG performance

A careful analysis of ESG metrics should have foretold of this Facebook data privacy scandal and portfolios which only targeted high ESG performers should have avoided it. According to MSCI, Facebook was “exceptionally vulnerable to regulatory actions and user dissatisfaction in case of privacy and data breach. Facebook’s controversial data collection and advertising practices have continued to trigger user complaints and regulatory actions.” That was before the Cambridge Analytica scandal.

For that reason, MSCI rated Facebook BBB on its ESG metrics, which isn’t high compared to other tech giants (see the table below). Facebook is a clear laggard in contrast to the A, AA and AAA rated companies. The social network giant should never have been included in any portfolio of ‘sustainable’ companies.

Measuring ESG performance requires rigorous analysis. Investors need to fully assess a company’s environmental, social and governance (ESG) footprint when making investment decisions.

Considering ESG factors in investment decision-making is both a quantitative and qualitative process. An example of a quantitative measure is assessing a company’s carbon emissions. With climate change one of the largest environmental challenges of the 21st century, stock exchanges around the world and investors are increasingly requiring companies to report their carbon dioxide emissions (CO₂e), which can be identified and measured.

Separately, careful analysis is required of a company’s policies, procedures and practices. Considerations as varied as labour standards, workplace diversity, efficient use of scarce resources, risk controls and management competency are part of a company’s social and governance footprint. This may be assessed through qualitative analysis and in some cases, quantitative measures.

MSCI is a leading global ESG researcher which rates companies on a ‘AAA’ to ‘CCC’ scale according to their exposure to industry specific ESG risks and their ability to manage those risks relative to peers. Well before Facebook’s latest troubles, MSCI had warned that data breaches and regulatory action were potential problems for Facebook, hence its BBB rating, lower than that of its peers.

CompanyMarket Capitalisation (US$bn)MSCI ESG Rating
Apple1,186.80A
Microsoft1,146.90AAA
Alphabet915.6AA
Amazon868.9BB
Facebook563.1BBB
Intel253.4A

Source: Factset, MSCI, VanEck. As at 31 October 2019

Carbon footprint

It is possible to measure the carbon intensity of a portfolio. Carbon intensity measures the efficiency of a portfolio in terms of carbon emissions per dollar of sales. While some ESG products contain exclusions they may fail to exclude companies that own fossil fuel reserves, or emit high levels of carbon. As the table below shows, the difference in carbon intensity between VanEck Vectors MSCI International Sustainable Equity ETF (ESGI), which tracks, the state-of-the-art MSCI World ex Australia ex Fossil Fuel Select SRI and Low Carbon Capped Index, and two other broad sustainable international ETFs.

ETFCarbon Intensity (tons CO2e/US$m sales)Weighted Average Carbon Intensity (Sum of portfolio weight x each stocks carbon intensity)
ESGI23.824.0
ETF 1189.7174.3
ETF 2174.183.8

Source: VanEck, MSCI ESG Research LLC 31 October 2019, Competitor ETF

If you are concerned with your portfolio’s carbon footprint you should invest in a portfolio with a low carbon intensity.

Good corporate citizens and transparency

Transparency and ESG investing should go hand in hand. You should be able to look at the holdings of your ESG portfolio every day and be comfortable that the portfolio holdings are in line with your own values. Among the most common anti-social and irresponsible activities companies can be involved in are:

  1. alcohol;
  2. gambling;
  3. tobacco;
  4. military weapons;
  5. civilian firearms; and
  6. adult entertainment.

If you cannot view the list of your ESG portfolio’s holdings to conduct your own due diligence, then your so-called ESG fund may have something to hide.

Many active fund managers incorporate ESG factors into their risk analysis. However, the challenge for many investors has been combining the inclusion of ESG leaders, exclusion of fossil fuels and carbon criminals and the exclusion of companies involved in anti-social or irresponsible activities into one portfolio. Many investments do only one or two of these. It has been particularly hard for passive managers, who track indices, to include effective qualitative ESG research.

VanEck’s two sustainable ETF meet all the requirements of responsible investing, including thorough ESG analysis. The holdings of all VanEck’s ETFs are available on our website, including our ESG focused, VanEck Vectors MSCI International Sustainable Equity ETF (ESGI) and the VanEck Vectors MSCI Australian Sustainable Equity ETF (GRNV).

In addition, we also make available a quarterly report to investors which outlines the carbon intensity and ESG exposure of these two portfolios:

IMPORTANT NOTICE:

This information is issued by VanEck Investments Limited ABN 22 146 596 116 AFSL 416755 (‘VanEck’) as responsible entity and issuer of the VanEck Vectors MSCI International Sustainable Equity ETF and the VanEck Vectors MSCI International Sustainable Equity ETF (‘the Funds’). This is general information only and not financial advice. It does not take into account any person’s individual objectives, financial situation or needs. Before making an investment decision in relation to the Funds, you should read the relevant PDS and with the assistance of a financial adviser consider if it is appropriate for your circumstances. The PDS is available at www.vaneck.com.au or by calling 1300 68 38 37. The Funds are subject to investment risk, including possible loss of capital invested. Past performance is not a reliable indicator of future performance. No member of the VanEck group of companies gives any guarantee or assurance as to the repayment of capital, the payment of income, the performance, or any particular rate of return from a Fund. The Funds are indexed to a MSCI index. The Funds are not sponsored, endorsed, or promoted by MSCI, and MSCI bears no liability with respect to the Funds or the MSCI Index. The PDS contains a more detailed description of the limited relationship MSCI has with VanEck and the Funds.

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