How ethical screening helps long-term portfolio returns

Photo of Arian Neiron, VanEck By Arian Neiron, VanEck

min read

ETFs provide simple, low-cost way to gain exposure to sustainable companies.

Investors are waking up to the importance of sustainable investing and increasingly realising that companies that take environmental and social considerations seriously and implement positive actions, are reducing financial and corporate risks and therefore are more likely to represent better long-term investments.

Sustainable investing involves taking environmental, social and governance (ESG) and ethical considerations into account to better assess and manage risk with the aim of generating sustainable, long-term returns. The result is an alignment of investor values with their investment objectives.

Positive and negative impacts
The most common form of sustainable investing is socially responsible investment (SRI), which aims to integrate non-financial factors such as ethical, social or environmental concerns into the investment process to achieve both financial and moral outcomes.

SRI is generally a “negative screen” process and works by excluding investments in companies involved in activities such as the production of tobacco, alcohol, military weapons and civilian firearms, gambling, nuclear power, fossil fuels and adult entertainment. These companies can have a negative impact on society or the environment.

Another aspect of sustainable investing considers ESG criteria, which may include both negative and positive screens and usually involves a rating system. ESG factors include such considerations as labour standards, greenhouse gas (CO2) emissions, workplace diversity, efficient use of resources and corporate governance.

Using ESG ratings to identify sustainable investments
One of the world's largest index providers, MSCI, is making sustainable investing easier by providing ESG ratings. MSCI has a team of more than 170 analysts worldwide assessing all stocks in its global universe on a AAA to CCC scale according to their exposure to industry-specific ESG risks and their ability to manage those risks relative to their peers.

These ratings help investors to identify companies that are acting responsibly and to avoid those that are not.

As an example, well before Facebook’s troubles with Cambridge Analytica emerged in March 2018, MSCI had warned that data breaches and regulatory action were potential problems for the social networking company.

The ESGI Index avoided Facebook because it ranks in the bottom quartile of MSCI’s Privacy and Data Security Key Issue analysis compared to industry peers with a score of 2.7/10.

Highly rated ESG companies help to drive returns
MSCI in 2017 released a research paper, Foundations of ESG investing, which evaluates how ESG characteristics have led to financially significant corporate performance. MSCI assessed the influence of ESG characteristics on cash flow and risk levels. It also quantified the impact of ESG momentum, that is, an improvement in ESG ratings.

In terms of cash flow analysis, MSCI found data supporting the assertion that high ESG rated companies were more profitable and paid higher dividends. The performance contribution of dividends to portfolio returns was increasingly important as investment time horizons lengthened.Neiron ethical etf

Source: MSCI

Second, in terms of risk, MSCI found that the share prices of companies with a high ESG rating typically have shown lower systematic and tail risk, as outlined below:

Source: MSCI

Finally, in terms of ESG momentum, MSCI found that improvement in a company’s ESG characteristics led to increasing valuations over time.

Separate analysis from Credit Suisse in 2015, Finding Alpha in ESG, found that integrating ESG factors can enhance portfolio performance through both lower exposure to negative risks related to ESG issues, and higher exposure to related opportunities, which can lead to material cost advantages, improved efficiencies and new revenue sources.

Credit Suisse also found that ESG ratings are a possible lead indicator of management quality in that companies that are better managers of ESG factors may also be better managers of shareholder capital.

Large investors focussed on ESG
Many active fund managers incorporate ESG factors into their risk analysis. However, the challenge for many investors has been combining the inclusion of ESG leaders, exclusion of fossil fuels and high greenhouse gas emitters, and the exclusion of companies involved in anti-social or irresponsible activities, into one portfolio.

Many managed investments do only one or two of these. It has been particularly hard for passive managers, who track indices, to target ESG leaders.

Another downside for investors is potentially high cost. Research house Rice Warner has previously stated that some Australian ethical managed funds charge “exorbitant fees”.

VanEck has overcome these challenges with its newly launched VanEck Vectors MSCI International Sustainable Equity ETF (ASX: ESGI). ESGI provides investors with exposure to a diversified portfolio of international companies meeting in-depth sustainability criteria, with management costs of just 0.55 per cent per annum.

ESGI tracks a new benchmark index, the MSCI World ex-Australia ex-Fossil Fuel Select SRI and Low Carbon Capped Index, developed in partnership between VanEck and MSCI. Several high-profile companies are excluded from the ETF’s Index, including Facebook.

The selection process involves high sustainability standards. Companies are identified from the MSCI World ex-Australia Index by a multi-layered screening approach as follows:

  • Excluding companies with fossil fuel reserves.
  • Excluding companies whose businesses are involved in non-SRI activities such as alcohol, gambling, tobacco, military weapons, civilian firearms, nuclear power, adult entertainment and genetically modified organisms.
  • Including only the leading ESG performers in each sector.
  • Excluding high carbon emitters.

ESGI enables investors to more easily and affordably access a portfolio of truly sustainable international companies in one trade on ASX.

About the author

Arian Neiron is the Managing Director and Head of VanEck Asia Pacific. Established in 1955, VanEck is one of the world’s largest ETF providers. This is article is not intended to provide financial advice of any kind.

From ASX

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