Free Idea: The Governance ETF

“Environmental, social and governance”—ESG—is a style of investing that selects companies that score best in those corporate areas, ranks them and uses them as underlying securities for various indices that investors can buy through an ETF or mutual fund. “Kumbaya” investing, it would seem, is going mainstream.

ETF.com fund reports now even carry MSCI ESG Analytic Ratings.

One Is Not Like The Others

Over the last few years of mulling over this second version of socially responsible investing—which is more judgment than quantitative analysis that forms index rules like ESG—one thing has always jumped out at me.

While these three positive corporate attributes sound great together, “environmental, social and governance” has an incongruent feel to it. I get it—the idea that if a company scores well in all three of these areas, it’s separating itself in a way that may appeal to certain investors, without sacrificing performance. Or so the pitch goes.

But one of these three seems out of place, from my perspective: governance.

Some companies succeed at promoting and supporting social, gender and income equality. It isn’t hard to conclude companies like that may also score well when it comes to the environment, fighting climate change and putting a green planet ahead of getting a green dollar back.

But a company can do all those things that push it to the top of the environmental and social corporate ladder, and still have a lousy cybersecurity system that ends up sabotaging its most valuable company asset, client data. Hello Equifax.

The breach of some 140 million Americans’ credit data is shocking on the surface, but MSCI’s ESG rating screener clearly had it on its radar.

MSCI flagged Equifax almost a year ago. This is from MSCI last month:

On September 7, 2017, Equifax revealed it was a victim of a cyber-attack potentially compromising 143 million U.S. consumers' sensitive information.

ESG signals can be critical in identifying outliers – positive or negative. In August 2016, MSCI ESG Ratings identified, and called attention to Equifax Inc.’s poor data security and privacy measures, which lead to its downgrade to ‘CCC’ – our lowest possible rating, and it was subsequently excluded from the MSCI ESG Leaders Index …

Scandals like Equifax, Volkswagen, Wells Fargo and Tesco call for, now more than ever, tighter screening of companies in the stock selection process, in order to mitigate Environmental, Social and Governance (ESG) risks in investment portfolios.

The MSCI governance screen also flagged VW and Wells Fargo before their scandals of cheating emissions tests (VW) and fraudulent sales practices (Wells) broke wide open.

Blocking Rather Than Picking

Keeping the bad actors off the stage is what this is really about, and I think it would make for an interesting ETF. Some funds nibble around the edge of this idea with forensic accounting screens, but plenty can be hidden behind a glowing bottom line that investors tend to fixate on.

And in the case of Equifax, for instance, news of the data breach was a like a torpedo to the bow of the stock and investors. Care to guess where on this 12-month performance chart of Equifax’s stock price the data breach news broke?

Chart courtesy of StockCharts.com

MSCI is not the only index provider offering ESG indices. FTSE Russell and STOXX have their own sets and methodologies, and some ETF issuers self-index their ESG funds. I wouldn’t be able to tell you which method is best for identifying the next Equifax torpedo, but the concept is proving itself.

Stripping out the “G” from “ESG” is similar to me as single factor versus multifactor ETFs, in that it maintains a rules-based construction.

Corporate incompetence isn’t isolated to any one industry: It lurks and can have an immediate and lasting impact on a public company and its investors.

As it stands now, you can use our ETF.com screener to filter out the best across all three ESG factors—but wouldn't it be cool to see a fund launch focused solely on the benefits of good governance?

Drew Voros can be reached at [email protected]