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Portfolio > Portfolio Construction > ESG

Why ESG Is Too Nuanced for Index Investing

By Frances E. Tuite

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The choice for active versus passive investing becomes more compelling when environmental, social and governance issues are layered into an investment thesis. Integrating ESG analysis into investment decisions is complex and therefore, we believe an active approach to ESG investing is needed and adds value.

ESG investing focuses socially responsible issues when selecting companies for a portfolio. However, ESG means different things to different people resulting in conflicting ESG risk profiles for the same company. In addition, company disclosures vary widely, providing inconsistent data with which to compare and construct a portfolio.

Active managers combine valuation, fundamental analysis and ESG factors into their stock selection. A passive or index strategy does not encompass individual stock selection; rather, stocks are added based on a positive or negative screen without regard to valuation or fundamental research. An active manager may create a select and concentrated portfolio (40 or 50 names) while passive funds may hold a large diversified portfolio (in some cases over 1,000 positions) that due to liquidity needs, out of necessity, can include stocks with low ESG ratings.

Vanguard’s ESG U.S. Stock ETF attracted $101 million recently, marking the largest weekly inflow for any socially-responsible fund since June, according to Bloomberg data. The fund’s assets grew 60% to $270 million. This ETF holds positions in Facebook and Amazon, which both receive low marks in various ESG metrics — Amazon for the treatment of their workforce and Facebook for its data issues. The MSCI ESG ETF also has high weightings in these same stocks, and it has exposure to fossil fuels.

Sector weightings also seem skewed for passive strategies that may favor sectors with more readily available metrics and data. For example, the Global Gender Equality ETF has a 32% weighting in financials. The S&P Fossil Fuel Reserves Free ETF has 20% in financials as well as a large weighting in technology, which include Amazon and Facebook. The large ESG ETFs all appear to own the same large cap stocks and have a heavy concentration in a few sectors.

And many of these ETFs hold stocks that have questionable sustainable records.

Active managers can sell a position when company management is not performing or up to their ESG standards, reacting more quickly to new information and independently.

Additionally, in-depth research by a dedicated active portfolio manager can add value by identifying companies that may have been ranked incorrectly by a global ranking service, or not ranked at all. The ranking may be dependent on the company’s disclosure or lack thereof.

Disclosure is not standardized, particularly on the social and environmental fronts. Many companies have begun to produce a corporate sustainability report that highlights all the accomplishments they choose to share and obviously shows them in the best light but may lack detailed data and targets, and certainly omits any negative data.

Active managers can engage with company managements and boards to effect real change toward greater transparency, disclosure, and sustainability. Passive managers have little or no engagement with management. Active managers place a greater weighting on good corporate governance practices, including Board diversification and gender equality, and actively vote their proxies and engage with management to improve policies and efforts in these areas.

A recent article in Barron’s (February 22, 2019), highlighted an example of the importance of analyzing corporate governance practices. While investors in Kraft Heinz stock suffered significant losses, Nuveen Asset Management avoided the stock because of its weak corporate governance (lack of an independent board) and environmental practices.

We strongly believe integrating ESG factors, and utilizing a fundamental, bottom-up valuation-based approach to investing should create long-term value for investors.

Frances E. Tuite is portfolio manager of the ESG Equity Strategy at Fairpointe Capital LLC.

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