ESG exchange-traded funds are having their day.
Over the past 10 years, ETFs with a focus on environmental, social and governance issues have fallen short of broad stock-market returns. But in the 12 months through March of this year, most ESG exchange-traded funds outperformed the broad market.
That is a promising omen for ESG funds, also known as sustainable, impact, or socially responsible funds. But it’s too soon to tell if the positive performance is sustainable. “Long-term studies show these funds have a chance to outperform, but you can’t draw any conclusions from one year,” says Hortense Bioy, director of passive-fund research in Europe for investment researcher Morningstar.
A study from research firm ETF.com shows that 26 of the 47 socially responsible ETFs that have been around for more than a year, or 55%, outperformed the broad market as represented by SPDR S&P 500 ETF Trust (SPY) for the 12 months through March 31.
That is quite a contrast to the 10 years ended that date. The eight funds that have existed for that period all trailed SPY’s 10-year performance, with only two coming close.
ESG exchange-traded funds also have drawn a growing amount of money from investors in the past couple of years. Net inflows totaled $1.43 billion for the 12 months ended March 31 of this year, up from $1.01 billion the previous year, making it the biggest inflow for any year ending on March 31 since 2008, according to Morningstar.
‘Money where their mouth is’
So what changed over the past year? “You can never reach into the mind of investors, but I’d like to say they are putting their money where their mouth is,” says Dave Nadig, managing director of ETF.com, a unit of Cboe Global Markets Inc. (CBOE) “We have heard that institutional investors are interested in ESG for a long time. Now we’re starting to hear from advisers that the same is true for individual investors,” particularly millennials and wealthy women.
Structural changes in the funds also have helped draw investors and boost performance, analysts say.
In the past, managers of ESG funds largely built their portfolios by simply eliminating stocks with negative ESG ratings, but recently their focus has turned more to choosing the companies that have the best financial performance among those with positive ESG ratings, reflecting a change in emphasis among investors.
“There has been an evolution,” Mrs. Bioy says. “Now investors prefer products with companies that are best in class in a certain category,” such as limiting carbon emissions.
To be sure, investors shouldn’t necessarily expect their 401(k) plans to be full of ESG options. The Labor Department, which oversees 401(k) plans, issued a notice in April saying companies “must not too readily treat ESG factors as economically relevant” to investing choices. “It does not ineluctably follow from the fact that an investment promotes ESG factors, or that it arguably promotes positive general market trends or industry growth, that the investment is a prudent choice for retirement or other investors,” the department wrote in its guidance.
Ground to make up
ESG-focused ETFs with 10-year records have all trailed the market (measured by the SPY fund).
|ETF||Ticker||10-year annualized total return|
|SPDR S&P 500||SPY||9.40%|
|iShares MSCI KLD 400 Social||DSI||9.28|
|iShares MSCI USA ESG Select||SUSA||8.87|
|VanEck Vectors Environmental Svcs||EVX||6.96|
|PowerShares Cleantech Portfolio||PZD||4.10|
|First Trust Nsdq. Clean Edge Green Nrg.||QCLN||-1.11|
|PowerShares Global Clean Energy||PBD||-5.58|
|VanEck Vectors Global Alt. Nrg.||GEX||-7.23|
|PowerShares WilderHill Clean Nrg.||PBW||-11.38|
Data through March 31, 2018 | Source: Morningstar
The top-returning ESG exchange-traded product over the past year was the exchange-traded note iPath Global Carbon ETN (GRN), with a return of 197%. That points to another factor boosting the category: improved statistics. “Ten years ago, finding out the carbon impact of a small-cap, emerging-markets company was impossible,” Mr. Nadig says. Now, data sets are more available, he says, widening the pool of stocks available to portfolio managers. In addition, fund issuers can do more-detailed research on companies’ financial performance, thanks to advances in analytics, so it’s easier for them to find the most promising stocks in that wider pool.
Another bullish factor for ESG funds over the past year is that newer entrants into the category have adopted a tighter focus. The top returners after GRN during the past year were WisdomTree China ex-State-Owned Enterprises ETF (CXSE), with a return of 52%; Guggenheim Solar ETF (TAN), 42%; WisdomTree Emerging Markets ex-State-Owned Enterprises ETF (XSOE), 27%; and Barclays Return on Disability ETN (RODI), 26%.
“The narrow focus makes it easier to find outliers,” Mr. Nadig says. “China ex-State-Owned Enterprises is a smaller set of securities, and the opportunity for outperformance goes up.”
Analysts warn, though, that those tight targets are a double-edged sword. “The narrower focus works in certain environments and hurts in others,” says Todd Rosenbluth, director of ETF and mutual-fund research at research firm CFRA. Chinese stocks and technology stocks generated stellar returns last year, while fossil-fuel stocks sagged. But that almost certainly won’t be the case every year. “The law of small numbers is that some will hit it out of the park, and some will strike out,” Mr. Rosenbluth says.
Another thing to keep in mind in considering the performance of ESG exchange-traded funds is that it’s difficult to tell how much the performance of the stocks they hold stems from ESG factors. Indeed, “what drives individual stocks often has nothing to do with ESG,” Mr. Rosenbluth says. For example, the top holding of iShares MSCI USA ESG Select ETF (SUSA), which returned 13% in the past year, is Microsoft Corp. (MSFT) “I’m not sure exactly why Microsoft did well last year, but it has less to do with ESG than broader demand for its products,” he says.
One approach for investors interested in ESG would be to treat funds that closely track broad market indexes as core holdings and funds that are narrower as satellite holdings, says Morningstar’s Mrs. Bioy. For example, SPDR S&P 500 Fossil Fuel Reserves Free ETF (SPYX) could substitute for the SPY S&P 500 fund as a core position. And the tightly focused funds cited above could be satellite positions.
Given that ETFs represent passive investments, what investors should hope for is returns in line with broad market indexes plus a psychic benefit, Mr. Rosenbluth says.