[This article appears in our March 2018 ETF Report.]
When it comes to performance, ESG ETFs catch a bad rap.
Some of them deserve it, of course: The oldest ESG ETFs—meaning, those that have been around for 10 years or more—have struggled to keep pace with the broader market long term (see Figure 1).
None of the eight oldest ESG ETFs outperformed the SPDR S&P 500 ETF Trust (SPY) over the past decade. Only two even came within striking distance: the iShares MSCI KLD 400 Social ETF (DSI) and the iShares MSCI USA ESG Select ETF (SUSA). In fact, half exhibited net negative performance over the past 10 years.
Given returns like these, who could blame the naysayers?
Yet the tides may be turning, because over the past year, ESG ETFs didn’t just beat the market, they crushed it.
Socially Responsible Killed It … In 2017
According to ETF.com data, there are 42 “socially responsible” ETFs with a track record of one year or more. Twenty-four of them—or 57%—have outperformed SPY over the past 12 months. Another four come within 1 percentage point (see Figure 2).
It wasn’t just a little outperformance, either. Eighteen funds (or more than a quarter of all ESG ETFs) surpassed SPY by more than 1 percentage point. Ten beat SPY by 5% or more. In fact, one ESG ETF—the WisdomTree China ex-State-Owned Enterprises Fund (CXSE)—was the third-best-performing nonleveraged ETF of 2017, rising more than 77% over the course of the year.
All this happened during a record bull market, where the stock market gained more than 26%.
Sure, one year of outperformance doesn’t wipe out years of middling returns. But it’s exactly the kind of performance ESG true believers have predicted all these years. So why are we only seeing it now?
Better Construction, Better Returns?
If you ask the issuers, they’ll tell you that the segment’s current highs are just a matter of product evolution.
When ESG ETFs first debuted, many funds used exclusionary screens as the primary way to winnow down their investable universe. Indexes for DSI and SUSA, for example, select their portfolios by first eliminating certain “vice” stocks, like tobacco and alcohol companies or casinos. Then the remaining stocks are ranked and weighted according to their adherence to ESG principles.
Exclusionary screens pose an existential problem, however: Knowing what investors don’t want doesn’t tell you anything about what they do want. As a result, wide disparity in ranking metrics, scoring systems, and even investment theses persists in the ESG space—to the point where a “biblically responsible” fund that specifically screens out LGBT-supporting companies and a fund that targets companies promoting LGBT workforce equality are both considered “ESG.”
Most ESG issuers will tell you that they’ve moved away from exclusionary screens, but that’s just marketing speak. The truth is, most ESG ETFs still implement some sort of vice-based elimination process to select their securities. Some do so as an explicit investment thesis, like the SPDR S&P 500 Fossil Fuel Reserves Free ETF (SPYX), which excludes companies that own fossil fuel reserves. Others, like the NuShares ESG Large-Cap Growth ETF (NULG), use screens as a first step, before then scoring stocks on proprietary metrics.
Narrower Focus = Better Returns
An explanation for ESG’s recent outperformance that may hold more water is that newer funds in the space tend to be narrower in focus, and in this case, narrow outperforms.
Four of the five top-performing ESG ETPs in the past year have narrow investment theses. The top performer, the iPath Global Carbon ETN (GRN)—which is nonetheless scheduled to be delisted in April—is an exchange-traded note that tracks carbon credits; it’s returned a whopping 117% over the past 12 months. GRN is followed by CXSE and the WisdomTree Emerging Markets ex-State-Owned Enterprises Fund (XSOE), both of which are based on the idea that private companies in developing markets perform better than government-run ones. After them comes the Guggenheim Solar ETF (TAN), which tracks companies in and serving the solar industry.
That said, plenty of broad-based ESG ETFs have also been outperforming SPY.
For instance, take the SPDR MSCI Emerging Markets Fossil Fuel Reserves Free ETF (EEMX), a broad-based fund that screens out coal, natural gas and oil companies from the MSCI Emerging Markets Index.
EEMX is the fifth-best-performing ESG ETF of the past 12 months, beating SPY by more than 17%. It’s also outperforming the non-ESG version, the iShares MSCI Emerging Markets ETF (EEM), by more than 6%.
Better Performance For Older Funds
Intriguingly, even many of the oldest ESG ETFs are currently beating the S&P 500. Five of the eight aforementioned ETFs with track records of 10 or more years beat SPY over a 12-month basis: the PowerShares WilderHill Clean Energy Portfolio (PBW), the PowerShares Cleantech Portfolio (PZD), the First Trust NASDAQ Clean Edge Green Energy Index Fund (QCLN), the PowerShares Global Clean Energy Portfolio (PBD) and SUSA.
Will the good times last, and 2018 prove to be as good a year for ESG as 2017? It’s impossible to predict, but certainly worth keeping an eye on. Maybe this time, good guys really will finish first.