During the past few months, a new suite of ETFs has emerged combining two popular themes: socially responsible investing and smart-beta factors.
These ETFs aim to achieve their dual mandate by selecting stocks based on a principle-based methodology, then applying further screens to match the ETF portfolio to a factor or multifactor investment style.
ETF issuers and index providers expect advisors to use these funds to implement strategic and tactical portfolio decisions while keeping their clients’ social concerns in mind. While these products have complex rules and methodologies, a quick overview on how these ETFs are built can help us understand this new and innovative niche in the ETF market.
Size & Style Definition
As of March 2017, there are 11 socially responsible smart-beta ETFs in U.S. markets. Their rigorous selection process starts by delimiting the investment universe of eligible securities. This crucial step sets up the initial constraints and characteristics of the ETF.
For example, as seen in the table below, the Oppenheimer ESG Revenue ETF (ESGL) selects its stocks exclusively from the S&P 500 Index, meaning that ESGL will only target large-cap U.S stocks. By limiting the universe of securities, the index provider can focus its attention on the particular market size and style it wants to apply to its ESG screens and factor methodology.
Underlying Indices & Investment Universe (by AUM)
|Ticker||Fund||Underlying Index||Investment Universe|
|ESGL||Oppenheimer ESG Revenue ETF||OFI Revenue Weighted ESG Index||S&P500 Index|
|ESGF||Oppenheimer Global ESG Revenue ETF||OFI Revenue Weighted Global ESG Index||MSCI All Country World Index|
|ISMD||Inspire Small/Mid Cap Impact ETF||Inspire Small/Mid Cap Impact Equal Weight Index||S&P Midcap 400 Index and Russell 2000 Index|
|NUSC||NuShares ESG Small-Cap ETF||TIAA ESG USA Small-Cap Index||MSCI USA Small Cap Index|
|ESGN||Columbia Sustainable International Equity Income ETF||Beta Advantage Sustainable International Equity Income 100 Index||MSCI World ex USA Index|
|NULG||NuShares ESG Large-Cap Growth ETF||TIAA ESG USA Large-Cap Growth Index||MSCI USA Growth Index|
|NUMG||NuShares ESG Mid-Cap Growth ETF||TIAA ESG USA Mid-Cap Growth Index||MSCI USA Mid-Cap Growth Index|
|NULV||NuShares ESG Large-Cap Value ETF||TIAA ESG USA Large-Cap Value Index||MSCI USA Value Index|
|NUMV||NuShares ESG Mid-Cap Value ETF||TIAA ESG USA Mid-Cap Value Index||MSCI USA Mid-Cap Value Index|
|ESGS||Columbia Sustainable U.S. Equity Income ETF||Beta dvantage Sustainable U.S. Equity Income 100 Index||MSCI USA Index|
|ESGW||Columbia Sustainable Global Equity Income ETF||Beta Advantage Sustainable Global Equity Income 200 Index||MSCI World Index|
Socially Responsible Screens
In the next step of the selection process, the index provider screens the stocks included in the investment universe, and selects those that adhere to its respective principle-based criteria. You can see the ESG method criteria used by these funds in the table below:
ESG Methodology & Ranking Criteria (by AUM)
|Ticker||Fund||ESG Methodology||ESG Ranking Criteria|
|ESGL||Oppenheimer ESG Revenue ETF||Sustainalytics ESG Scoring||Top 50% categories|
|ESGF||Oppenheimer Global ESG Revenue ETF||MSCI ESG Research Ratings||Top 50% rank|
|ISMD||Inspire Small/Mid Cap Impact ETF||Inspire Impact Score||Biblical Values and positive impact|
|NUSC||NuShares ESG Small-Cap ETF||TIAA ESG Methodology||ESG Leaders and Carbon Emissions Screens|
|ESGN||Columbia Sustainable International Equity Income ETF||MSCI ESG IVA Methodologie||No lower than BB|
|NULG||NuShares ESG Large-Cap Growth ETF||TIAA ESG Methodology||ESG Leaders and Carbon Emissions Screens|
|NUMG||NuShares ESG Mid-Cap Growth ETF||TIAA ESG Methodology||ESG Leaders and Carbon Emissions Screens|
|NULV||NuShares ESG Large-Cap Value ETF||TIAA ESG Methodology||ESG Leaders and Carbon Emissions Screens|
|NUMV||NuShares ESG Mid-Cap Value ETF||TIAA ESG Methodology||ESG Leaders and Carbon Emissions Screens|
|ESGS||Columbia Sustainable U.S. Equity Income ETF||MSCI ESG IVA Methodology||No lower than BB|
|ESGW||Columbia Sustainable Global Equity Income ETF||MSCI ESG IVA Methodology||No lower than BB|
Most of these funds use a proprietary ESG ratings. Usually, these methodologies rank companies based on how well each company manages its environmental, social and corporate governance (ESG) practices.
For example, MSCI’s model makes adjustments depending on each industry ESG risk exposure and how well a company’s management mitigates or takes advantage of each ESG risk:
- Environmental risks include themes such as carbon emissions, natural resources usage, pollution and waste management.
- Social risks consist of themes around labor health, safety and human capital development, product life liability, and stakeholders conduct.
- Corporate governance risks embody themes such as board structure, pay, business ethics and transparency.
Principle Value Screening
Some indexes also exclude companies from their investment universe to better align their products to their principle values.
As an example, the Inspire Small/Mid Cap Impact ETF (ISMD) aims to select companies associated with biblical values, thus excluding companies with any degree of participation in abortion, gambling, alcohol, pornography, LGBT lifestyle, or doing business in terrorist-sponsoring countries.
In other cases, such as NuShares’ funds, their indexes exclude any company that owns fossil fuel reserves, as part of their carbon-screening criteria.
Adding Smart-Beta Factors To Mix
What sets these funds apart from other socially responsible ETFs is the inclusion of smart-beta factors. These factors, as developed by Eugene Fama and Kenneth French, are the key drivers of equity risks and returns.
Advisors can take advantage of these factors to tilt a portfolio according to the risk tolerance of their clients or to outperform a market portfolio.
Index providers achieve exposure to these factors by either screening stocks or modifying the weight of the securities in an ETF portfolio based on a particular fundamental factor. The table below lists the different factors used by these ETFs:
Smart-Beta Factor (by AUM)
|ESGL||Oppenheimer ESG Revenue ETF||Sales|
|ESGF||Oppenheimer Global ESG Revenue ETF||Sales|
|ISMD||Inspire Small/Mid Cap Impact ETF||Size: Small Cap tilts|
|NUSC||NuShares ESG Small-Cap ETF||Size: Small Cap tilts|
|ESGN||Columbia Sustainable International Equity Income ETF||Dividend|
|NULG||NuShares ESG Large-Cap Growth ETF||Growth|
|NUMG||NuShares ESG Mid-Cap Growth ETF||Growth|
|NULV||NuShares ESG Large-Cap Value ETF||Value|
|NUMV||NuShares ESG Mid-Cap Value ETF||Value|
|ESGS||Columbia Sustainable U.S. Equity Income ETF||Dividend|
|ESGW||Columbia Sustainable Global Equity Income ETF||Dividend|
NuShares funds obtained factor exposure by using a predefined investment universe of stocks geared toward a factor.
Oppenheimer funds instead use a proprietary revenue weighting to outperform its benchmark.
Columbia funds use a proprietary factor ESG alongside dividend yield to seek income opportunities. An equal-weighting scheme is also used in ISMD to tilt the ETF portfolio to small-cap stocks to benefit from the company size factor.
New ETF Marketplace Niche
By adopting smart-beta traits into ESG products, ETF issuers are betting on a growing demand for socially responsible products.
Still, these ETFs are young, and have only just begun to gather assets, and fund closure risks are latent. Nonetheless, this is an exciting new idea in the ETF marketplace, and if these products prove successful, expect socially responsible investing to enter other areas of the ETF space, such as international ETFs or fixed-income ETFs.
At the time of writing, the author did not own any of the securities mentioned. Luis Guerra can be reach at [email protected].