Chief executives ignoring ESG risky for investors

Exxon board usurper Engine No.1 launched an ETF last week


Maybe the risk about environmental, social and governance (ESG) investing is backward.

The common narrative is that the risk rests on an investor’s shoulder, a potential sacrifice of returns for the greater good in the world.

But with recent activist action shaking up the Exxon boardroom, there is an ESG move afoot and boards of directors are in the crosshair.

Companies who ignore the movement toward answering to ESG standards in the boardroom are putting their investors at risk. This is a trend that is only gaining steam as time goes on.

ESG concerns coming at corporate boards

ESG is a way to invest money in a manner that aligns with our personal values, but it can also serve as a framework to think about risk management.

If a company chooses to ignore any ESG factors, there is a growing risk to the company that did not exist before as these issues come more into focus.

This thought is illustrated by the recent chatter around Engine No. 1, which launched its Engine No. 1 Transform 500 ETF (VOTE) this week.

The firm had recently succeeded in putting three candidates on Exxon’s board of directors. Though the firm owned only a small portion of Exxon’s shares, it had won the board seats by persuading other shareholders to join their mission.

Engine No. 1’s success, and subsequent fund launch, could be the turning point when it comes to bringing impact investing into the spotlight and onto corporate radars.

ESG ETFs seeing flows

Even before the launch of this fund, however, there was no denying that investor interest in ESG has been growing. In Europe, ESG ETFs outpaced non-ESG inflows in 2020 with €43.8bn inflows, according to data from Lyxor.

Furthermore, new ESG ETFs are being launched regularly, not only from niche players but from the largest issuers in the ETF game. The most successful of these launches has been the SPDR Bloomberg SASB US Corporate ESG UCITS ETF (USCR) which has gathered $5.6bn assets under management (AUM) since launch in October 2020.

Even in the US, in absolute levels, net flows into ESG ETFs are higher this year relative to the same time period last year, with over $21bn flocking to ESG strategies so far.

This underscores the point that these issues are growing in importance to investors. Companies will have to face various ESG factors head-on in order to please not only their consumers but their shareholders.

No single definition

Without a doubt, the biggest hurdle facing investor adoption is that, as of yet, there is no industrywide standard for what makes an ESG ETF. Socially responsible, impact investing, ethical investing are all terms also used to describe the space.

And of course, different funds have different methods for what constitutes “ESG” in their screens.

And when it comes to clients, there is a fundamental misunderstanding facing advisors. Client perception often focuses on environmental factors and “negative screening” – excluding certain industries such as oil or coal.

Certainly, some ETFs rely on these types of rules to construct their portfolios. Other ETFs, like the Lyxor MSCI World Catholic Principles ESG UCITS ETF (CATH), might exclude companies that are not aligned with a specific religion’s values. But the full meaning of ESG is not well-understood. There is more to it than “environmental”.

One thing to keep in mind is that excluding entire segments of the market can lead to periods of at least short-term underperformance should these industries catch a bid.

For example, if oil- and gas-related stocks exhibit a period of strong performance, portfolios that do not hold these names could underperform those that do. However, many ESG investors have said this is a risk they are willing to take if they feel good about the investment.

Kind of excluded…

Other ETFs might not entirely remove specific industries, but instead establish certain thresholds for exclusion.

For example, the iShares MSCI USA ESG Select ETF (SUSA) uses categorical exclusions for some categories but relies on a revenue threshold for others.

Companies involved in businesses such as alcohol, gambling or civilian firearms are excluded, while tobacco companies may be included if they are classified as a distributor, retailer or supplier yet earn less than 15% of their revenues from tobacco products.

The benefit of using this type of methodology is that businesses can often be involved in several different industries. Investors will not miss out on the potential performance of these companies by excluding them from the portfolio if only a tiny portion of their revenues come from a specific business line.

Do not ignore the social

Other ESG ETFs might take a more thematic approach, meaning they focus on one specific sustainability theme. Here, the possibilities for themes are seemingly endless.

The Lyxor Global Gender Equality UCITS ETF (ELLE) invests in companies according to 19 criteria such as high proportion of women in executive and director positions. Others, like the Impact Shares NAACP Minority Empowerment ETF (NACP), select companies based on social criteria defined by the NAACP. Others focus on areas like clean energy or water infrastructure.

With many options out there and no two investors having the same values, the hurdle for investors will be in taking an inventory of which principles should take priority, and then identifying which funds are most in line with these principles.

Data pitfalls abound

Even when the methodology underlying an ETF’s ESG mandate is clear, the industry still has a ways to go in building out and standardising the data on how each company fares on certain metrics.

These metrics are much fuzzier and harder to pin down than statistics like market cap or valuation that might be used in building traditional indices and products.

Here too, there are signs that the tide is changing. Earlier this week, Gary Gensler, chairman of the Securities and Exchange Commission (SEC), noted that he has asked staff to put together recommendations on mandatory company disclosures on climate risk and human capital.

His rationale for this action was specifically due to increasing investor interest and the need for disclosure to facilitate the efficient allocation of capital across the market.

The risks to companies that do not consider ESG factors is growing as investors further consider these issues.

Companies that refuse to consider ESG factors face risks that did not exist just a few years ago. The evolution of new standards for boardrooms and investors is in full motion. Adapt or face the consequences.

This story was originally published on ETF.com

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