On Investments

ESG investing: Assessing the 'E,' 'S' and 'G'

Mutual funds that invest based on environmental, social and governance factors are all the rage. But is one factor more critical to performance?

Dec 19, 2017 @ 4:00 pm

By John Waggoner

During the holiday season, we like to turn our thoughts to good things: Puppies, charities and gift-wrapped Ferraris 488 GTBs.

We may also turn our attention to investments that concentrate on a company's environmental, social and governance score. And rightly so: ESG mutual fund and ETF assets have grown to $111.4 billion, from $56.8 billion five years, ago, according to Lipper.

ESG first came into the public view via funds that concentrated on the "S" — social — part of ESG. And, while that's the warmest part of ESG, it's also the fuzziest. Early social investment funds, such as Pax Balanced Individual Investor (PAXWX), launched in 1971, initially focused on avoiding objectionable companies: Major polluters, for example, or tobacco companies.

Most people agree that tobacco companies are bad — you really should try to avoid killing your customers — but other sections of the "S" portion are widely debatable. Amana Mutual Funds Trust Income Fund Investor (AMANX), for example, avoids interest-paying debt because paying interest is not in accordance with Islamic principles. One could also make the argument that a strong defense department is a social value, and include arms makers in the mix — something that most of the old-style social investment funds don't do.

The case for avoiding companies with rotten environmental records is good: No one wants to own a company that gets massive fines or loses lawsuits because the river next to its factory keeps catching fire. And in recent years, avoiding energy companies entirely would have been a brilliant move: The Standard & Poor's 500 has lost 30% since June 2014, according to S&P. Avoiding energy would have boosted the S&P 500 return to 45.46% from 37.24% during that period.

"There are two premises to ESG screens," said Steve Janachowski, CEO of Brouwer & Janachoski. The first one is that we shouldn't be supporting bad companies, however we define that. But that's a philosophical point of view; it's not an investment thesis. The other is that a company should perform better because its costs are lower or because people will support it."

The best argument, then, for ESG is the G: Governance.

Companies with consistently good governance tend not to be hit by disaster, such as the Equifax data breach and the Wells Fargo scandals.

"It's critically important, and something we place a good degree of emphasis on," said Ben Johnson, director of global ETF research at Morningstar. "There have been several companies, such as MSCI, that had flagged the problems at Equifax and did a victory lap."

Governance is particularly important for international funds. One popular index — Japan's JPX-Nikkei 400 Index, the so-called "shame index"— weighs stocks not only according to earnings, but their conformity with international disclosure and governance standards. As its name implies, not being on the shame index is a cause of, well, shame, and Japanese companies strive hard to get and stay on it. Three ETFS — iShares JPX-Nikkei 400 ETF J(PXN), iShares Currency Hedged JPX-Nikk 400 ETF (HJPX) and Xtrackers Japan JPX-Nikkei 400 Eq ETF (JPN) — follow the index.

While there's no pure governance funds, Morningstar rates several funds and ETFs on their governance scores, and those at the top tend to fare well. For example, iShares MSCI USA ESG Select ETF (SUSA) has consistently ranked in the top half of its Morningstar category the past decade, and is edging out the S&P 500 this year. NuShares ESG International Develped Markets Equity ETF (NUDM), a newer offering, also ranks high on Morningstar's governance ratings, and has jumped 25.5% this year, vs. 24.03% for the average large-company blend fund.

Another ESG fund that gets high marks for governance and performance is Parnassus (PARNX), which emphasizes companies that treat employees well. It has beaten the S&P 500 by more than two percentage points a year the past decade.

Money that flows into ESG funds tends to be sticker than money flows into other types of funds, notes Todd Rosenbluth, senior director of ETF and mutual fund research at CFRA. Those who are motivated enough to move into an ESG fund are most likely to stick with it.

ESG has yet to become a big force in investing: Although its growth has been impressive, it comes from a low base. Perhaps that will change: It would be good to know that more people are putting their money where it will do the most good.

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