Incorporating ESG As Equals
From FlexShares: ESG investing, or investing informed by facts about a company’s environmental, social, and corporate governance policies and practices, is a hot topic in investing circles. ESG considerations have moved into the investing mainstream. How are investors, their advisors, and corporate managers integrating ESG factors?
What does ESG integration mean?
ESG integration is the process of incorporating the analysis of ESG factors into the overall mainstream investment analysis procedure used by investors, financial advisors, and money managers as they seek the best companies to include in their funds and portfolios.
Pax World Funds makes a case for ESG integration by pointing out that by 2030, women will control two-thirds of the world’s wealth. They also mention that between now and the middle of the century, some $30 trillion in wealth will be transferred to millennials. Both women and millennials, in comparison to the current generation in control of much of the world’s wealth, are more inclined to factor ESG issues into their investment decisions. [1]
Why integration makes sense
ESG’s key performance indicators (KPIs) are about more than just doing the right thing within these categories. We believe not doing them can pose real, tangible risks for companies. KPIs are quantitative and qualitative metrics that demonstrate how effectively a company is achieving its business objectives, which often include environmental, social or governance considerations.
Violating environmental rules can cause companies to be fined and required to make expensive modifications to their business processes. These can be significant costs with potentially other penalties associated with this as well.
Social factors can also pose risks. If the company is engaged in a business where employees are killed or injured due to unsafe aspects of a manufacturing process, the company could be subject to regulatory actions and lawsuits from the impacted employees and their families.
Governance factors, such as executive compensation and board diversity, offer opportunities for potential growth if handled well and we believe pose real risks, both legal and in terms of public relations, if handled poorly.
Our approach to integration
These reasons, among others, are why we launched our two ESG-focused ETFs. The integration of ESG factors into our core investment analysis guides the selection of holdings for our two funds:
FlexShares STOXX® U.S. ESG Impact Index Fund (ESG)
FlexShares STOXX® Global ESG Impact Index Fund (ESGG)
We feel the best way to innovate in the ESG space is to integrate ESG-related KPIs into an investment strategy. One way to do this is to identify the materiality of each key performance indicator. Ideally, we believe that material KPIs potentially impact risk/return with strong predictability.
Our focus is on integrating indicators that exhibit a substantive or material impact on the long-term sustainability of the firm’s business model, along with its share price performance, into our process for analyzing and selecting holdings for these funds. Our analysis has illustrated that some KPIs exhibit significant impacts while others are less significant. Likewise, the impact varies on a sector-by-sector basis. For example, KPIs for food producers are different from those for steel companies. [2]
We believe saying that ESG is “nice to have” doesn’t cut it in today’s environment. These are critical business issues offering real potential opportunities and posing equally real risks. Our research suggests that not integrating ESG into the mainstream of financial analysis poses concerns for values-driven investors.
References
[1] Pax World Fund, “Integrating ESG Analysis to Manage Indeterminate Risk,”, http://paxworld.com/system/storage/19/6f/7/4532/integrating_esg_analysis.pdf
[2] FlexShares.com, Why ESG May Finally Gain Traction, https://advisors.flexshares.com/insights/insights-detail?c=bc2680b96dd5efd06491ef7e81e6db4a
Written in conjunction with Roger Wohlner utilizing Contently. Roger is an experienced financial writer whose work has appeared on Investopedia, US News, Morningstar Magazine and MSN Money.
FlexShares STOXX® US ESG Impact Index Fund (ESG) and the FlexShares STOXX® Global ESG Impact Index Fund (ESGG) are passively managed and use a representative sampling strategy to track their underlying index respectively. Use of a representative sampling strategy creates tracking risk where the Fund’s performance could vary substantially from the performance of the underlying index. The Funds are subject to environmental, social and governance (ESG) Investment Risk, which is the risk that because the methodology of the Underlying Indices selects and assigns weights to securities of issuers for non-financial reasons, the Funds may underperform the broader equity market or other funds that do not utilize ESG criteria when selecting investments. The Funds are also at increased risk of industry concentration, where it may be more than 25% invested in the assets of a single industry. For ESGG, investments in foreign market securities involve certain risks such as currency volatility, political and social instability and reduced market liquidity. The Funds may also invest in derivative instruments. Changes in the value of the derivative may not correlate with the underlying asset, rate or index and the Funds could lose more than the principal amount invested.
The STOXX® USA ESG Impact Index and the STOXX® Global ESG Impact Index are the intellectual property (including registered trademarks) of STOXX® Limited, Zurich, Switzerland and/or its licensors (“Licensors”), which is used under license. The securities based on the Index are in no way sponsored, endorsed, sold or promoted by STOXX® and its Licensors and neither of the Licensors shall have any liability with respect thereto.
An investment in FlexShares is subject to numerous risks, including possible loss of principal. Fund returns may not match the return of the respective indexes. The Funds are subject to the following principal risks: asset class; commodity; concentration; counterparty; currency; derivatives; dividend; emerging markets; equity securities; fluctuation of yield; foreign securities; geographic; income; industry concentration; inflation-protected securities; interest rate / maturity risk; issuer; management; market; market trading; mid cap stock; natural resources; new funds; non-diversification; passive investment; privatization; small cap stock; tracking error; value investing; and volatility risk. A full description of risks is in the prospectus.
The FlexShares STOXX US ESG Impact Index Fund (NASDAQ:ESG) was unchanged in premarket trading Tuesday. Year-to-date, ESG has gained 11.92%, versus a 11.31% rise in the benchmark S&P 500 index during the same period.
ESG currently has an ETF Daily News SMART Grade of NR (Not Rated), and is unranked among 118 ETFs in the Large Cap Blend ETFs category.
This article is brought to you courtesy of FlexShares.
