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Global investment and business community is increasingly incorporating ESG principles. Remarkably, investors are limited in their choice in passive and active instruments to play the sustainability-theme. This may have a reason, since returns are not (yet) competitive. In a world driven by cold hard yields, the consequences of the operations of companies is sometimes neglected. Investors could well forget the values they believe in when investing for a secure retirement. We often are quite firm in our discussions in how we view the world, politics and society, but do not always incorporate our believe in our portfolios. Yes, we search for trends and reflect on how different technologies could shape the world and therefore future profits, but do we also consider whether companies and products can shape a world in which we want to live? Sustainable investing is the investment approach that considers global social and environmental challenges while building a portfolio. To be fair, there’s an increasing amount of consideration for ESG-policies (Environmental, Social and Governance). Even Harvard Business Review’s list of the Best Performing CEOs considered ESG-criteria, often making or breaking a CEO’s ranking in the list. Yet, there’s still some reservations against sustainable and ESG investing among investors. There might be some prejudice against ESG and sustainability. Surely complying at ESG and sustainable criteria will cost companies money? Being more aware of waste, a more diverse working force and higher transparency (to name a view) would come at the cost of yield, some investors may think. But is this really true? Let’s find out! There are a number of ways to approach sustainability. According to US SIF (The Forum for Sustainable and Responsible Investment), “sustainable, responsible and impact investing is an investment discipline that considers ESG criteria to generate long-term competitive financial returns and positive societal impact. I put long-term competitive in italics here, since that is what we want to find out. Note that returns are put ahead of social impact. When looking at ESG-criteria, a number of company policies are identified. For example, focus on Environment means that the company has policies related to resource management and reduction of emissions i.e. reducing ‘footprint’. Social-criteria point to diversity, health, human rights, safety and community impact. Governance stands for shareholder rights, board accountability and disclosure, to name a few. The items mentioned above indicate that a company doesn’t need to be a second Greenpeace or Amnesty International to comply in order to be considered for a sustainable investment approach. For instance, Microsoft’s (NASDAQ: MSFT ) goal to go carbon neutral would make the shares of the company attractive for investment. Since a large number of S&P 500 companies are stepping up their commitment to ESG-criteria, the investment universe is quite large. Remarkably, there are not a lot of ETFs with a sustainable or ESG-based approach on the US market. Currently there are only two (relatively small) ETFs which have a multiple year track record: iShares MSCI USA ESG Select ETF (NYSEARCA: KLD ) and iShares MSCI KLD 400 Social ETF (NYSEARCA: DSI ). Early last year, ALPS launched its Workplace Equality ETF (NYSEARCA: EQLT ), which is very small however with only a little less than USD 10 million AUM (assets under management). Passive investors are therefore limited in their choice. However, the number of actively managed products is a bit larger, with US investors able to choose from 7 mutual funds. Unfortunately, not all of them have a track record of more than three years. In addition, the investment mandate may be global or restricted to a specific ESG-theme. Therefore, only 3 mutual funds are selected for a performance check, bringing the total to 5 instruments. Let’s first start with the ETFs. iShares MSCI USA ESG Select KLD seeks exposure to socially responsible U.S. companies and excludes tobacco companies. It tracks the MSCI USA ESG Select Index. The underlying index is designed by MSCI’s propriety ESG rating framework. Companies are reviewed by MSCI analysts on more than 500 data points and scores on 100 indicators. Companies get a rating that falls on a nine-point scale (AAA to CCC). The index is reviewed on a quarterly basis. KLD has an expense ratio of 0.5% and thus is more expensive than a regular US market ETF, such as the popular SPDR S&P 500 ETF (NYSEARCA: SPY ) (expense ratio of 0.09%). iShares MSCI KLD 400 Social DSI is based on the more restrictive MSCI KLD 400 Social Index. This index not only excludes tobacco, but also securities from companies involved in nuclear power, alcohol, gambling, weapons, GMOs (genetically modified organisms) and adult entertainment. In addition, companies should have a ESG-rating of above BB. DSI is therefore the ‘purest’ sustainability ETF on the US market. The performance of both ETFs are compared to SPY. A direct comparison to the S&P 500 as the broader market doesn’t make sense, since we’re looking for an evaluation of passive investments. (click to enlarge) The table leads to a clear conclusion: on the longer term, sustainability or ESG ETFs do not offer a competitive return. Although all three ETFs show a small positive return this year, over a 5-year period we see a significant underperformance. What is even more disturbing: a stricter interpretation i.e. better compliance to ESG values seems to lead to lower returns. But there’s a glimmer of hope: on a 3year basis, KLD beat the market. All three ETFs have a similar development over time, as the chart below shows. For neutral ETF-investors, there hardly seems an incentive to switch to more ESG-friendly instruments. (click to enlarge) Can active management provide a reason to move to sustainability? Let’s look at our mutual fund selection: Touchstone Sustainability and Impact Equity Fund (MUTF: TEQAX ) One of the older sustainability-themed mutual funds is managed by Touchstone Investments. The fund is active since December 1997 and therefore has a long track record. The asset manager is sub-advised by Rockefeller & Co. Inc. since May 2015. The investments are selected based on an evaluation of company’s ESG-practices. The investment process follows a bottom-up approach. DFA US Sustainability Core Portfolio (MUTF: DFSIX ) Dimensional Fund Advisors offers two mutual funds in the SRI-category: DFA US Sustainability Core Portfolio and DFA International Sustainability Core Portfolio (MUTF: DFSPX ). On top of that, it offers the DFA US Social Core Equity Portfolio which has a social oriented mandate. For comparison with the US market, DFSIX is included in our check. Northern Global Sustainability Index (MUTF: NSRIX ) The last product in our check is actually not an actively managed fund. NSRIX seeks to replicate the MSCI World ESG Index. Surprisingly, it has a lower expense ratio (net 0.31%) compared to the ETFs described earlier. Asset manager Northern Trust offers this mutual fund for the ‘socially conscious’ investor. The fund and its underlying MSCI index seek to track the performance of companies that comply to widely accepted sustainability principles. This instrument is included in the comparison to see how a global ESG-oriented allocation performs compared to the US market. Investors should be aware of the restrictions that come with investing in above mentioned instruments. The instruments are not available by all brokers and do have a minimum investment threshold which can run up to USD 2500. Also fees for redemptions may apply. As always, consult your financial advisor before making any investment. In our performance analysis, we ignore the indicated benchmarks of the mutual funds. Since we want to see if actively managed ESG-based strategies are competitive, the performance is compared to the broader market measured by the S&P500 Index. Neutral investors who look for an incentive may be less interested in specific benchmarks, but look for an outperformance on the broader market. This is of course arbitrary, but a comparison to different benchmarks would be of lesser use. Since the S&P 500 Index is a price based index, we should also look at the S&P 500 Total Return Index (SPTRX). All three mutual funds distribute dividends. (click to enlarge) The table above doesn’t give reason to become enthusiastic about sustainable and ESG investments. The underperformance compared to the broader market can’t be explained by higher costs, although a part can be contributed to (higher) expense ratios. When we look at the more recent yields and the return since the start of the bull market, actively managed instruments are performing slightly better that their passive counterparts. It should be highlighted that the DFA US Sustainability Core Portfolio is able to outperform the market on several timeframes. But this could be explained by good management and isn’t necessarily attributable to ESG-criteria, as its peers show. For now, the available instruments for sustainable and responsible investing do not show the competitive returns we hope to see. Neutral investors which are only interested in return are not offered an incentive to switch. Unfortunately, this leaves the investment category only interesting for a specific group of investors. Scalper1 News
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