Potential & Challenge Of ESG ETF Investing

October 01, 2019

Should Investors Be Compensated For Taking ESG Risk?

Proponents of efficient market investing may argue that investors should expect lower returns when investing in highly rated ESG companies that operate with lower financial risk.

In a rational capital market, investors should not be compensated for taking on lesser risk. Highly rated ESG stocks tend to trade at premium valuations versus the broader market, but this could be cyclical rather than structural.

However, highly rated ESG stocks also tend to produce higher returns on capital and are more highly profitable. Academic research has shown “profitability” to be historically rewarded with higher excess returns (see Fama/French/Novy-Marx).

3 in 1 – 1 in 3?

What one tends to see is that the ESG category fund scores are highly correlated to one another, suggesting a fair degree of intersectionality across ESG.

In other words, a fund that is highly scored in the environmental category will also likely have high scores across socially conscious and governance categories. One wonders whether there is a methodological bias to the scoring process. Can a coal mining company with a poor environmental score receive a higher score in socially conscious and governance? Are ESG investors really getting exposure to three distinct categories, or just one supercategory?

Asset Allocation: Stacking The ESG Deck

Using ETF data from Morningstar, we produced average overall and individual ESG category scores for various equity fund categories, which are displayed in Figures 2a and 2b. Morningstar ESG Scores range from the mid-30s to the mid-60s. We want to focus attention on the yellow-highlighted categories.

 

Figures 2a & 2b: ETF Fund Categories: Average Morningstar ESG Fund Scores

Source: Morningstar (8/31/2019)

 

Some interesting observations stand out:

  1. European-focused funds tend to score at the top, while emerging market funds (primarily China and India) tend to score at the bottom.
  2. Large cap funds score better than midcaps, which score better than small caps. In fact, small cap funds tend to have worse scores than emerging markets.
  3. There is no real significant difference between value and growth funds, which is a little surprising given the factor loadings mentioned earlier.

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