By: Dave Rudd
Director of Sandbox Limited
Are ESG (environmental, social and governance) factors real considerations, or are they merely a marketing ploy?
Before the rise of ESG (responsible investment, sustainable investment, whatever you want to call it), most ‘ethical’ investment involved the use of screens. Non-profits ‒ especially pension funds for religious groups ‒ would prohibit investments in so-called sin stocks ‒ alcohol, tobacco, firearms. However, with the turn of the 21st century and more concern over the environment, climate change and dwindling resources, the focus of mainstream investment started to shift.
However, here’s the rub. By creating ESG as an investment consideration, it became hard to eliminate any stock from a portfolio. As long as companies met environmental standards, could show a social conscience or had some sort of sound business practice, they had to be considered to be partially ESG compliant. Also, since ESG has three components: climate, governance and an empathetic, progressive approach to its employees and society, fund constructors needed to score and trade off a social good for, say, an environmental good.
Our use of The Sandbox tool bears this out. Tesla was at the forefront of electric vehicles and the driving force in building out a charge station network across the US, but seems to only get a grudging allocation from ESG ETFs. Indeed, the ESG ETF that allocates to Chevron and Exxon does not list Tesla in its Top 10 and may not allocate at all. More broadly, allocations to US$ ESG funds look to the untrained eye like tech-focused investments with an outsized allocation to Nvidia being very common.
In attempting to understand ESG fund investments a little better, we used Sandbox to examine the 98 US$ ETFs that advertise themselves as ESG or climate focused. We also noted that there are about 62 Canadian $ ETFs that describe themselves as ESG focused. We also looked at 162 US ESG mutual funds and 40 Canadian ESG mutual funds. Some of these funds do contain various share classes of the same strategy.
Actionable ETF ESG Catalogues
Since Sandbox is uniquely suited to the task, we did an analysis of how these ETFs play together. The results were interesting. First, we put all 98 US ESG/climate ETFs side by side, but it’s cumbersome. Then we thought we’d look at the 20 US ESG ETF funds offered by Blackrock iShares. We then reviewed those US ESG ETFs with a common history of four years. Here’s the common VAMI history:
Blackrock iShares ESG ETFs Common History
Then we separated US ESG debt ETFs from US ESG equity and created two groups. Let’s compare an equally weighted common history portfolio of US ESG debt ETFs with equity ETFs:
iShares ESG Debt vs ESG Equity
We then used the Sandbox finder tool and searched all ETFs for correlations to our custom average of US Equity ESG ETFs. We found that our custom basket of equally weighted iShares ESG ETFs was highly correlated to non-ESG ETFs including broad equity indices. Actually, the return profiles are almost indistinguishable from hundreds of ETFs as shown below ‒ note the 99% correlation to John Hancock MultiFactor, Flexshares Morningstar ETF and many others such as Dow Jones, Russell 3000 & S&P 500.
ESG Equity ETFs…high correlation to the broader ETF Equity Universe
High Correlation to many non-ESG ETFs
We then looked at the holdings of US ESG ETFs and found they were/are very similar to US non-ESG ETFs ‒ basically, finance and tech in both categories. Is that appropriate for ESG? While it doesn’t appear investors are paying a premium for an ESG-designated fund, we have to ask if these ESG designations seem like a virtue signalling exercise than making a substantive difference. Is the bar too low?
For instance, in almost all cases, Nvidia, the producer of AI chips, is typically the largest holding of ESG ETFs. The best performing ESG ETF, (33% in the 12 months to Aug 2024), had an outsized 16% allocation to Nvidia with the next largest allocation being less than 4%. Comment/Call me on that one.
Emerging Market ESG ETFs
Sandbox noted that Emerging Market ESG ETFs performed poorly compared to US ESG ETFs. The absence of Nvidia and its counterparts is partly the reason. As well, emerging market ESG ETFs were focused on Asia with an outsized allocation to Taiwan Semiconductors (TSM.US) and Chinese tech/finance (Alibaba, Tencent etc). The result was that EM ESG ETFs were highly correlated to each other. The chart below incorporates ETFs that identified themselves as EM ESG ETFs …as shown below.
Emerging Market ESG ETFs…very correlated & with similar underlying investments
US ESG ETFs dramatically out perform EM ESG ETFs
Imploding values in Chinese equities and capital flight out of China have generally kept EM equities on the defensive. With the recent massive liquidity announcement from China, expect some rebound and some return to an historical relationship. Is this the start of a trend? Time will tell. Some are skeptical about China’s genuine interest in supporting western-style markets.
What can we conclude from this Sandbox analysis?
First, the analysis bears out the premise that all companies worth investing in will somehow/someway meet a standard for ESG compliance. The best ESG and non-ESG returns that include companies that don’t meet these standards are probably not worth investing in.
The bottom line is that both ESG and non-ESG ETFs show the same return patterns. And when, for example, something spooks investors like the fears over a hardline China, asset flows into both ESG and non-ESG ETFs slow in a similar fashion.
Comments? I’m interested in hearing yours. Reach out to me at info@sigmasandbox.com or (9) David Rudd | LinkedIn. Or visit the website www.sigmasandbox.com.
Sandbox is a highly visual, interactive app for understanding and building investment portfolios. The visual interface helps users examine and improve their portfolios. Its complementary public and private fund data is unique, yet simple to navigate and investors can integrate their own data and portfolios with Sandbox data for more focused analysis. www.sigmasandbox.com
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