A problem with legacy environmental, social and governance products is they can be highly exclusionary, and that means there is an automatic bias that can impair performance against standard benchmarks such as the S&P 500 or Russell 1000 indexes.

These are indexes against which many managers are measured and could be the reason why ESG asset flows across advisor channels have been weaker than the tidal wave of funds flowing from institutional investors. So states a paper from FlexShares, “The Integrated Core Approach to ESG: The Case for the Next Generation of ESG Investing.”

Instead, today’s ESG funds should focus on the “holistic” approach of building a portfolio that “has a securities selection methodology that adheres to a total return and risk-adjusted return idea,” Abdur Nimeri, senior investment strategist for FlexShares ETFs, told ThinkAdvisor.

Abdur Nimeri.

“The legacy of [early ESG funds] is still pretty much seared into the minds of a lot of money managers, and so on the retail side that imprint has been pretty significant,” Nimeri says, noting that as far back as the 1990s ESG funds weren’t highly diversified, which impacted performance. However, today there is more data available that shows impact to shareholder value as well as what variables impact volatility and other factors, he says, adding that as more “gatekeepers of wealth” come online, “we will see more financial advisors come [in], and I imagine, more assets.” He sees ESG practices flowing into all spaces, including ETFs and mutual funds, but variable annuities as well.

Zeroing In With KPIs

In designing ESG portfolios, Flexshares focuses on key performance indicators or KPIs, reported by companies in their regulatory filings — basically non-financial disclosures, according to Nimeri.

These KPIs fall into the three ESG buckets. For example, under environmental, KPIs would measure electricity use, total water usage and regulatory risk exposure. Under social, they would measure community spending and human rights policies. For governance, they could track the percentage of women on the board and poison-pill plans.

In using these KPIs, which are extensive, according to the report, it is possible “for asset managers to develop and apply systematic investment strategies that evaluate a company’s risk and opportunities by examining its [ESG] indicators,” the report states. “Combining this type of information with traditional financial analysis and security selection is a textbook example of ESG integration.”

Nimeri says for today’s advisor who “has to make longer-term decisions for generational wealth transfer, or institutions that have to think about beneficiaries holding capital for longer periods of time to pay out benefits, their decision-making process is different. We found [for example] that they think in terms of not climate change, but climate risk, in sustainable portfolios going forward.”

In other words, they are thinking about “headline risk” or factors that “will impair their shareholder value,” Nimeri says.

To innovate ESG, Flexshares decided the best way was to “integrate ESG-related KPIs into an investment strategy,” according to the report. To do this they identified materiality of each KPI and its impact on risk/return. This had to be done sector by sector as each has its own KPIs, i.e. KPIs for food producers were different than steel companies. Companies were scored accordingly.

“We want the best ESG scoring names in each sector and each industry,” Nimeri explains. “So we remove the bottom 50% on a sector-by-sector basis, and retain the top 50% scoring ESG names. And once [that’s done, we] found that portfolios that do that use a best-in-class methodology.”

This means all sectors are included, including energy, Nimeri says. “[The methodology] does two things. It allows the portfolio to breathe, and allows the portfolio to have complete exposure across all sectors. It allows for broad-based diversification,” he says.

To put this methodology into ETF form, Flexshares worked with Stoxx to do an analysis of ESG KPIs “to see if indicators that lead to long-term value creation for shareholders could be identified.”

Selecting the most influential KPIs from each of the three ESG buckets, and selecting stocks from the Stoxx Global 1800 index, the firm developed two ETFs, the FlexShares Stoxx US ESG Impact Index Fund (ESG) and FlexShares Stoxx Global ESG Impact Index Fund (ESGG). Excluded were any companies that don’t adhere to the U.N. Global compact principles or are involved in any controversial weapons or coal mining.

But pulling from all sectors, the ETFs have a diversified approach. As of Sept. 30, 2018, the ESG fund was made up largely of tech companies (29.03%), including Microsoft, Amazon, Apple and Alphabet, but also included Exxon Mobil (2.93%). At that time the ETF’s return since inception (July 2016) was 17.56% versus 16.95% for the Russell 1000 index.

The U.S. fund, which has $33 million in assets (its global counterpart ESGG has $78 million in assets), was transferred to Cboe Global Markets from the NYSE on Dec. 28, 2018.

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