Trade-offs: High Level ESG Scores vs Specific Tilts

Now that we have looked at how ESG considerations and index construction methodologies can impact the ESG characteristics of indices, it is time to delve deeper into specific issues. For instance, rather than optimizing high level ESG scores, an investor may want to primarily optimize the environmental (E) and governance (G) scores without regard for the social (S) score. Or an investor may want to focus on more specific or objective issues such as lower emissions or gender equality. Again, we will be looking at a single fund that is well-known, tracks a well-known benchmark, and is sufficiently scored by a well-known ESG analytics firm. Not comprehensive a study, but illustrative of some basic dynamics.

This particular fund targets low greenhouse gas emissions and avoids owning fossil fuel reserves, while also divesting from stocks with severe controversies. The emissions metrics look great as shown below:

Fund Benchmark
Tonnes of CO₂ per $1M invested 37 103
Tonnes of CO₂ per $1M of sales 58 206

Source: Bloomberg,

However, the fund’s distribution of ESG scores tells a different story, as shown below:

Source: Bloomberg

The fund (green area) is overweight companies in the lowest-scoring decile of ESG scores and underweights nearly all of the better-scoring deciles (relative to its benchmark index, the red area). Thus, this particular fund appears to achieve its emissions goals at the expense of its high level ESG score. What is an investor to do?

Some investors may want to take a balanced approach and modestly improve the high level ESG scores of their portfolio. Other investors may want to focus more on emissions or gender equality or some other issue, using a fund like the one above. It is also possible to act in a more nuanced way by blending the two approaches, although this can be difficult with the existing universe of ETFs and mutual funds. A word of warning to do-it-yourselfers though: consider the above tradeoffs when constructing a portfolio, as bolting together different funds could result in unexpected exposures (ie. a low carbon fund might more than offset the positive ESG characteristics of an ESG-optimized fund).

There are no perfect portfolios. Just as traditional investors must prioritize returns, risk, volatility, liquidity, and so on, ESG investors must prioritize what factors are important to them. There is no “right” way to invest, nor is there a “right” way to invest responsibly. Investors must determine what is important to them and then decide which trade-offs they are willing to make.

ESG Approaches: Divestment vs Best-in-Class

The below comparison is obviously not a comprehensive study or representative of the many inherent nuances, but I do believe it illustrates something that I frequently find when evaluating off-the-shelf ESG investment products (such as mutual funds and ETFs). Below are two large-cap index ETFs from the same sponsor using the same ESG rating provider.

  • The first fund (orange) screens out a minimal amount of industries and then weights companies based on their respective ESG ratings.
  • The second fund (grey) screens out a much larger number of industries and then simply weights the remaining funds by market cap.
Source: Bloomberg

The distributions look pretty similar. The first fund (orange) primarily shifts allocations from decile 10 towards decile 8. Is this materially different or better than the second fund (grey)? I would argue no. The mode, median, and mean may look different, but the underlying scores are not necessarily better or worse. Here’s the same data graphed in a different format:

Source: Bloomberg

I’ve looked at many SRI/ESG index products that use various screening and weighting methodologies, but I have not found major differences in the distribution of ESG scores between funds that take an exclusionary approach versus the ones that take an optimizing approach. The net effect of either approach is basically to shift the quality of ESG factors to the right. There may be minor differences around the edges, but I have found the distributions to be largely similar. Again, this relates primarily to index-based strategies.

What does this mean? It means that there are multiple approaches to improving the ESG characteristics of indices. Excluding the “bad” stuff or simply underweighting it often produces similar results. Both approaches can shift a distribution of ESG rankings similarly. Investor motivations, constraints, and objectives will determine the best approach to take (and I don’t advocate one over the other). Ideally, investors can integrate both approaches, although this can be a bit more difficult to execute well.

Integrating ESG into Index Investing

Two of the main arguments made by ESG advocates are that  “values can impact value” and “ESG factors correlate with better corporate financial performance.” I’m sympathetic to both arguments, although they both seem better suited to an active management context (due to higher levels of portfolio concentration and greater emphasis on fundamental analysis). Yet, as investors increasingly shift assets from active to passive, it is worthwhile to examine how ESG considerations impact index characteristics.

The below is not meant to be a comprehensive study, but simply illustrative of what investors can expect from a plain-vanilla ESG-oriented portfolio. The red area (below) represents the distribution of high-level ESG scores (from a well-known ESG analytics firm) for the portfolio of traditional large-cap index fund. The green area represents the same distribution, but applied to an ESG-themed large-cap index fund that optimizes for ESG score.

source: Bloomberg

This particular fund is fairly representative of many ESG-themed funds and receives good high level ESG scores from multiple ratings firms. While the distribution is shifted meaningfully to the right, it is still a relatively modest shift. This is not meant perjoratively as radical shifts often result in unacceptable risks and/or tradeoffs.

Below is the same data in a different format, but with the same conclusions: there is a slight shift of weighting from companies in deciles 2-5 towards companies in deciles 8-10.

source: Bloomberg

When investors are optimizing for high level ESG scores, it is important for passive ESG investors to understand the above dynamics and to maintain reasonable expectations in terms of objectives, portfolio characteristics, and performance. This is especially true when considering the uncertainty surrounding high level ESG ratings (see here and here), the increasing amounts of “greenwashing,” and questionable claims from some sponsors and managers.

Correlation of ESG Scores From Different Providers [One More Chart]

Recently came across the below chart, which illustrates the weak correlation in company-specific ESG ratings from different providers (which I wrote about earlier this week). Even though the below uses slightly different data sets than my previous post, the R² is remarkably similar. I’ve heard other experts reference correlations in .3 to .4 range, which seems consistent with the below and my previous post. I believe the takeaway is the same: the scores are directionally similar (the below dots generally move from bottom left to upper right), but the correlation is relatively loose.

source: Sustainable Brands (via

ESG Scores: Correlations Between Providers

Two weeks ago, we looked at Facebook which is included in many ESG-themed indices and funds despite corporate governance concerns and a recent data privacy scandal. Some ESG managers even divested from FB following the scandal. Although Facebook is the most recent example, there are divergent views and competing opinions regarding the ESG characteristics of many companies.

A quick glance at some of the largest ESG funds reveals that there is a range of opinions regarding many companies, from JP Morgan to Exxon Mobil to Netflix. Some ESG funds own these names and some do not. We can see this visually by pulling ESG ratings from two different providers for companies in the S&P 500 index. The results (below) are all over the place with a weak correlation. Upon first glance, it appears that ESG factors (like other investment factors, such as quality or value) are in the eye of the beholder.

source: Bloomberg

However, things look much different at the fund level. Below are the respective ESG scores from two large ESG ratings firms for some of the largest large-cap ESG index ETFs. The correlation is much higher and the scatterplot falls within a much tighter range (blue lines). Sure, there are differences in methodology, holdings, and weights, but the aggregate ESG ratings are similar.

source: Bloomberg

This is similar to relationships that we find in the traditional investment world. For instance, value funds weighted by P/E, P/B, P/CF, dividends, CAPE, and so on, may all have different holdings and weights, but they largely share similar characteristics and factor tilts.

Just as investors should not get too hung up on the high level numerical ESG scores or use subjective judgments arbitrarily, it does help to understand the inputs, assumptions, and overall methodology of the ESG ratings. The ESG ratings of individual companies can vary wildly, but a larger portfolio (such as a mutual fund or an exchange-traded fund) will diversify a lot of that variability away (as shown above). However, funds are constructed in a variety of ways and there are both better and worse ESG funds out there, so investors still need to look under the hood to know what they own.

Why is FB an ESG darling, in light of the Cambridge Analytica scandal?

The recent Cambridge Analytica scandal at Facebook has brought up an interesting question for ESG investors: if data privacy had been highlighted as a risk at FB, why did FB have such a high ESG score and why is it one of the top holdings of many ESG funds?

To answer the first question of why did FB have such a high ESG score, it may be helpful to review what ESG is and what it is not.

  • Environmental, Social, and Governance (ESG) issues are risk factors and ESG scores cannot predict the future any more than financial metrics like price-to-book (P/B) or return-on-equity (ROE) can. Both financial and non-financial metrics can help investors tilt their portfolios, but they cannot help investors select individual winners and losers.
  • Data on ESG factors is collected from many sources with varying levels of quality and completeness. The ESG ratings providers evaluate this data and provide both objective and subjective reporting. Just as investors should not blindly purchase investments with a five-star rating from Morningstar, investors should not blindly invest in something just because it has a high ESG score.
  • Identifying risks is only half the battle. Accurately estimating a risk’s probability and its impact is the other half. BP had relatively high ESG scores prior to the Deepwater Horizon oil spill, as did VW before its emissions scandal and FB prior to the Cambridge Analytica debacle. Even though ESG risks had been identified, the perceived probability of the aforementioned events had been too low. That being said, estimating traditional financial risks or ESG risks is difficult (if not impossible) and surprises are by definition unexpected.
  • Risk is only one side of the equation. Even if an investor had underweighted FB as recently as a year or two ago, that investor would have missed out on substantial returns. Such a person may argue that FB’s environmental (E) score more than compensated for its governance (G) score. A skeptic may say that the investor deemed the data privacy issues worth returns (especially in light of FB’s private data-dependent ad revenue and the relatively rapid rebound that we’ve seen in its share price from the scandal-driven selloff). Either way, ESG are a set of risk factors to be evaluated, not to arbitrarily exclude/include.

To answer the second question about why FB is a top holding of many ESG-themed funds, it may be helpful to think of ESG funds similarly to how we think about dividends funds or other factor-based funds. For those that rely solely on ESG scores or buy index funds based on ESG scores, it is important to understand how the sausage is made and understand what limitations exist. A familiar parallel may be the dozens and dozens of dividend-oriented index funds, which are constructed using a variety of methodologies. Why are some companies included in some funds and excluded from others? Investors should evaluate how their funds are constructed, what is in them, and decide if it matches their desired exposure. Whether a fund focuses on ESG, dividends, or anything else, I encourage investors to understand how the fund is constructed and what trade-offs exist. The simple answer is that FB is a top holding of many ESG indices due to how the indices are constructed; simply read the prospectus and you’ll discover how FB was included and weighted.

ESG analysis, like anything else in investing, is not easy. It’s a framework for thinking about risk rather than something that can be reduced to numerical score and blindly relied upon. At best, it helps investors make better decisions and incrementally improve the risk/return characteristics of their portfolios.

Breakout Alert: $TNX

source: Bloomberg

Don’t look now, but the yield on the 10-year UST is breaking out of a 33-year downtrend. I do not know what this portends, but that trendline is very long and has been incredibly strong, so the breakout is worth noting.

Should we be worried about the trade deficit?

As the president has ramped up his tweeting about America’s trade deficit with China and is threatening a trade  war,  it  is important to remember that running a trade deficit is not a terrible thing. As Warren Buffett noted at the recent Berkshire Hathaway shareholder meeting,

“When you think about it, it’s really not the worst thing in the world for someone to send you things you want and you hand them a piece of paper.”

This is especially true if you print the pieces of paper and the Chinese cannot effectively do anything with that paper besides buy US Treasuries with it. Obviously, there are other reasons that a country may want to produce some good/service domestically (instead of importing it), but eliminating a trade deficit in and of itself is not a great reason. Unfortunately, the word deficit has a negative connotation and so I do not expect this perennial political talking point to disappear anytime soon.

Housing Supply Remains Low

Source: NAR, Bloomberg

This chart just hit my inbox and is a decent visual representation of last week’s post on why the housing market continues to appreciate despite higher mortgage rates and less favorable tax treatment of mortgage interest and property tax under the new tax law. Ignore the narratives, just look at supply and demand.

Of Condemned Houses and Asset Shortages

Don’t look now, but the SF Bay Area housing market is on fire. A few weeks ago, a burned out house in San Jose sold for $800k and made national headlines. Now my town Fremont is making the news with a CONDEMNED home that sold for $1.23M.

Condemned house sells for $1.2 million in Fremont

There are logical explanations such as high rents and low rates support such prices and/or the buyers of the two aforementioned properties can tear them down and build a new structure with instant equity. Of course, that equity relies on today’s rates and/or prevailing prices. I’ll make no predictions on the direction of prices, but I will say that the supply and demand of assets often influences prices a lot more than economic fundamentals. This goes for nearly all assets from real estate to equities to fixed-income to cryptocurrencies and so on. For my fellow Bay Area folks, do please try to ignore the various narratives and ex-post rationalizations for why our real estate prices are hyperbolic; we simply have an extreme imbalance of supply and demand resulting from years of underbuilding. This is what an asset shortage looks like. Yes, “asset shortage” typically refer to “safe haven” assets like Treasuries, but when you live in a region where South and East Asian immigrants are the marginal buyer, real estate in a decent school district fits the bill.