‘E’ Is For Environmental

[This article appears in our March 2020 issue of ETF Report.]

Climate change has become a major concern for many investors, as more people consider the record-breaking summer heatwaves in Europe, massive hurricanes in the Caribbean in the past few years, and the Australian wildfires as more than weather oddities.

For many environmental, social and governance (ESG) investors, the “E” is paramount. Meggin Thwing Eastman, executive director and research editorial director for MSCI ESG Research, notes their clients’ No. 1 environmental issue is climate change.

Yet finding ETFs with the highest environmental ratings can be tricky. Investors first need to decide what their top environmental concerns are: Is it carbon emissions? Water quality? What about deforestation?

Ratings from ESG data providers can help, but the data they use and their methods aren’t standardized. Research Affiliates notes there are 70 firms providing ESG ratings, not including other organizations conducting ESG-related research, all with their own ideas of what ESG means.

But there are ways for investors to discover the highest-rated environmental funds that align best with their views. It just takes a little legwork.

Creating Ratings
Eastman says that MSCI’s flagship ratings methodology assesses the long-term resilience of companies. Regarding environmental ratings in particular, MSCI looks at what issues are most financially relevant for a firm. For example, a miner would have several environmental risk issues, so MSCI will assess those risks in different ways, and the firm’s environmental score could have a heavier weight in its overall ESG score.

MSCI reviews a company’s operations, business segments and the typical profile of those segments. They also consider the individual firm’s risk exposure within its industry compared with its peers and how the company manages those risks.

That process is repeated for different issues across “E,” “S” and “G,” with the riskiest aspects getting the greatest weights. Those are averaged together and weighted for an overall company rating, and one that’s relative to the rest of the industry. The scores are rated 1-10, with 10 being the highest, and from AAA to CCC, similar to credit ratings.

For ETF ratings, Eastman notes that the fund’s underlying holdings drive quality ratings. There’s a weighted average of the holdings, and MSCI adds a momentum factor for funds, giving a slightly higher score to a fund holding companies with improving ratings, compared with a fund whose company ratings have declined over time.

Dig Deeper
For investors, taking ratings at face value is just the start. Feifei Li, head of investment strategy at Research Affiliates, recently published an article, along with her colleague Ari Polychronopoulos, comparing ESG ratings between two well-known providers.

The article, “What a Difference an ESG Ratings Provider Makes!” suggests the lack of consistency between ESG data providers’ methodologies means each can evaluate the same company differently, potentially leading to drastically different outcomes when these ratings are used to construct a portfolio.

That’s why financial advisors researching ESG investments need to do extensive due diligence with ESG raters.

“You actually need to look into the metrics they’re using, the attributes they’re interested in, and even to a degree, the weighting methodology to make sure metrics you care about are assigned a significant weight,” Li said.

Andrew Behar, CEO of As You Sow, a nonprofit shareholder advocacy group that has a website that reviews 3,000 funds on various ESG metrics, says ESG raters are hampered by a lack of standardization regarding how a company discloses ESG data—if they disclose anything at all.

“Right now, a lot of ESG raters are just looking at company websites and trying to figure something out,” he said. “And they’re all figuring it out a little differently.”

‘E’ Is More Standardized
Of the three ESG categories, Li notes their study shows the environmental category had the highest correlation between the two providers studied, whereas social and governance had lower correlations. Part of that reason stems from more environmental data being reported by companies because of pressure from investors and regulators, she explains.

Because of that, investors seeking highly rated environmental ETFs could have an easier time finding a fund that’s consistently highly ranked.

“I think there’ll be products offered that can closely satisfy your need,” she said. “But I’d say that due diligence is important so that you know exactly what they’re doing.”

Reviewing Funds
Eastman notes it’s hard to make broad generalizations across funds when considering ESG, that it’s better to focus on industries or sectors. ESG investors can use MSCI top 20% peer ranks to help highlight the top funds in each industry or sector. It makes for more of an “apples to apples” comparison, she says.

Certain industries may have higher environmental rankings than others. For large cap funds, four of the top 10 ETFs ranked by Confluence Analytics are technology-focused ETFs. Top environmentally focused midcap and small cap ETFs are a little more varied on sectors.

“Technology-related companies rank highly on “E,” as they’ve been very vocal on instituting measures to be carbon neutral in the operations that mainly involve data centers’ energy use,” said Conor Platt, founder and president, Confluence Analytics. “Microsoft, for example, just announced its intention to be carbon negative by 2030.”

One rater’s highly ranked fund may not jibe with another. On AsYouSow.org, investors can enter ETF and mutual fund tickers to see how funds measure on various ESG metrics, and how they stack up financially against broader benchmarks like the S&P 500 or Russell 2000. For people looking for fossil-fuel-free funds, As You Sow’s methodology takes financial data from Morningstar, then applies five different screens, such as coal miners or companies with fossil-fuel reserves.

An example of one of the highest-rated fossil-fuel-free ETFs on AsYouSow.org is the Etho Climate Leadership U.S. ETF (ETHO), which has a sustainability mandate and 0% investments in fossil fuels, a low-carbon footprint and carbon intensity compared with benchmarks.

However, ETHO isn’t in MSCI’s peer rank and only receives a BBB rating from MSCI, with a score of 5.54.

Still, ratings can help investors weed out artfully named environmental funds. Consider the recently closed Pickens Morningstar Renewable Energy Response ETF (RENW), which did not receive MSCI’s top 20% peer ranking, and AsYouSow.org rated it an “F” for having 35% of assets involved in fossil fuels. Morningstar’s sustainability score put it in a higher-risk category.

Picking Funds
Kostya Etus, senior portfolio manager at CLS Investments, points out his firm uses Morningstar’s ESG ratings to find funds. He likes Morningstar’s partnership with Sustainalytics because of how Sustainalytics looks at environmental risk.

He chooses funds by category rank first and takes into consideration that not all asset classes are the same: “We want the best ESG ETF as compared to its peers, and then as a subcomponent we look at the carbon risk.”

His top pick is the Change Finance U.S. Large Cap Fossil Fuel Free ETF (CHGX), which has an MSCI top 20% peer ranking and gets a low-carbon rating from Morningstar for having no fossil-fuel holdings.

Etus says that more clients are interested in ESG, especially on the environment metric, but it’s still something he’s more likely to bring up to clients than for them to ask him.

“It’s really about education,” he noted. “If more people know what [ESG rankings] are, there’ll be more interest.”