Can ESG Investors Finally Have It All?

Innovation in the exchange-traded fund (ETF) space just reclaimed the shareholder vote for those looking to put their money in environmental, social, and governance (ESG) focused investments. The ESG conundrum—the trade-off between active risk and impact investing—is no more.

For many market participants, this has been a long time coming. ETF innovation, once the force behind bringing passive investing to the masses, has lately been focused on asset-manager self-preservation as fund companies search for opportunity in a crowded ETF landscape. Smart beta, active management, options strategies, thematic investing, and ESG deliver active risk and high fees, yet often fail to deliver on their promise of risk-adjusted outperformance.

Bringing Activist Proxy Voting to the ETF World

Newly launched Engine No. 1 Transform 500 ETF (VOTE-US) offers investors a low-cost, passive portfolio with activist proxy voting.

ETFs democratize investing by making institutional strategies available to all investors big and small at a near-zero price tag. ETFs such as SPDR S&P 500 ETF Trust (SPY-US), Vanguard Total Stock Market ETF (VTI-US), and iShares Core U.S. Aggregate Bond ETF (AGG-US) have attracted hundreds of billions of dollars because they maximize coverage while minimizing active risk. These funds allow investors to take on market risk without the uncompensated risk of over- or under-weighting sectors or specific companies. They cost almost nothing.

But there’s one aspect of passive investing that’s not always aligned with investors’ interests. Fund investors have no mechanism to influence corporate governance via shareholder votes. Proxy voting has been left to the asset managers who often answer to a broad client base with diverse and potentially contradictory values. Moreover, asset managers can have multiple relationships with the corporations whose stock they hold, some of whom are also clients. While many ETF providers have updated their proxy voting policies, activists, especially those focused on climate, remain dissatisfied. It’s no wonder that ESG investing has taken off.

Yet investors who wish to express their values in their investment portfolios faced a trade-off. The cost of ESG investing is active risk—taking bets against the market. Whether the ESG strategy involves avoiding certain industries or companies or focusing on those that best adhere to a stated value set, ESG portfolios have been different from the overall market. That difference, known as active risk, is unlikely to be rewarded over the long term as periods of outperformance are usually balanced by underperformance.

Despite the claims that ESG screening produces outperformance by reducing risk without compromising returns, ESG ETFs have historically performed in-line (risk-adjusted) with their market segment benchmarks. The table below contrasts the number of ESG ETFs with sufficient history against the number that out- or under-performed their segment benchmark on a risk-adjusted basis using a generous 90% certainty threshold.

ESG ETF Performance Compared to Benchmark

Source: FactSet

The five-year statistics show that ESG ETFs generate alpha more frequently than random chance would predict, but there’s a catch: one of those three ESG ETFs’ alphas was negative. Of the eight ESG ETFs with a five-year history, five performed in-line with risk taken, two outperformed, and one underperformed.

The biggest success of the eight ESG ETFs with more than five years of history has been the iShares MSCI Global Impact ETF (SDG). Notably, SDG’s chart shows a long period of underperformance from inception through February 2020. That’s the downside of active risk.

SDG Has Both Over- and Under-Performed the Broader Market

VOTE’s broad-based vanilla portfolio of U.S. large cap stocks takes virtually no active risk, as it holds every one of the largest top 500 U.S. stocks, save for a handful that failed a liquidity screen. Its ESG-ness comes not from stock picking, but from exercising its shareholder power in proxy voting.

Power is the right word here. ESG via security selection doesn’t carry any influence unless huge populations of investors go on the same buyer’s strike or pile into the same favored companies—enough to sustainably suppress or elevate a stock price. ESG fund performance suggests that buyers of non-ESG stocks remain plentiful. Buying shares does not necessarily send a message to corporate boards and C-suites.

Proxy voting directly affects corporate governance. Indeed, VOTE’s investment adviser, Engine No. 1, just backed four candidates for Exxon Mobil’s board—and won three seats. Engine No. 1 formed an alliance with Vanguard, SSGA, BlackRock, CalPERS, CalSTRS, and the NY State Common Retirement Fund, creating enough voter power to effect change.

VOTE’s prospectus states, “The Fund seeks to encourage transformational change at the public companies within its portfolio through the application of proxy voting guidelines and dialogue with management of the portfolio companies. The proxy voting guidelines…encourage companies to invest in their employees, communities, customers, and the environment. “

By harnessing a previously underutilized investor asset, Engine No. 1’s VOTE returns power to its fund holders. VOTE’s mandate includes investment efficiency and ESG effectiveness. This is the ETF innovation that many ESG-minded investors have been waiting for.

Disclaimer: The information contained in this article is not investment advice. FactSet does not endorse or recommend any investments and assumes no liability for any consequence relating directly or indirectly to any action or inaction taken based on the information contained in this article.