On Dec. 31, Index Universe published a helpful survey of funds based on environmental, social and governance (ESG)-screened indexes. Lorne Abramson, a California-based adviser and manager, compares the strategies, costs, and performance of a number of exchange-traded and separately-managed index funds.
"Investing Responsibly" addresses two persistent misconceptions about ESG investing:
1) ESG screens limit returns by imposing sector bias on portfolios.
2) ESG investing is a "boutique" approach that conflicts with conventional investment strategies.
Mr. Abramson argues that ESG can play a complementary role in portfolio construction:
"The focus of this survey is ultimately from the standpoint of ESG as an 'overlay' component, building upon the fundamental investment principles of global asset class diversification, frictional cost minimization and tax efficiency. In other words, it assumes ESG is not a separate asset class, but a means of investing in existing, traditional asset classes."
Unbalanced Indexes Can Still Outperform
Mr. Abramson acknowledges that ESG screening does introduce sector bias to some indexes. This may be deliberate, as part of a "green" strategy focusing on clean-tech firms, for example. Other funds, such as the recently launched FaithShares ETFs, may avoid those businesses, like gambling or alcohol production, that conflict with certain religious teachings.
The world's longest-running ESG-screened index, the FTSE KLD 400 Social Index (KLD400), is tracked by an iShares exchange-traded fund (listed as DSI). Historically, the KLD400 has been somewhat underweight in energy and basic materials, and overweight in financial and technology stocks. This sector bias helps explain why the KLD400 outperformed the market in the late 1990s, during the "tech bubble."
For the record, since inception, the KLD400 has outperformed the S&P 500, delivering annualized returns of 9.51%, versus 8.66%, as of 12/31/09. It has also outperformed at the 1-, 3- and 5-year marks. (The KLD400 lagged at the 10-year mark, at the end of the "tech bubble.")
Select Social Index Seeks Sector Neutrality
Mr. Abramson also mentions the iShares ETF based on the FTSE KLD Select Social Index (SSI). The SSI seeks to closely track the sector composition of its benchmark, the large-cap FTSE All-World US Index. This index includes strong ESG performers from sectors like energy and basic materials. As explained by the SSI's methodology:
"The FTSE KLD Select Social Index (SSI) is optimized to maximize exposure to positive environmental, social, and governance factors while exhibiting risk and return characteristics similar to those of the FTSE US 500 Index. The Index is sector-diversified, holding companies with the highest social and environmental scores from each sector."
Click here to see SSI performance data. Since inception, the SSI has delivered annualized returns of 2.41%, versus 2.26% for its unscreened benchmark. Like the KLD400, the SSI has outpaced its benchmark over 1-, 3-, and 5-year periods.
Other Options in an Expanding Marketplace
"Investing Responsibly" discusses other passive-strategy ESG funds, and considers the industry trend towards globalization. For example, Pax World and Northern Trust have launched ESG products based on KLD global benchmark indexes.
While he notes that "there are still noticeable asset class gaps" in the marketplace, Mr. Abramson foresees "growth and innovation continuing in both the ESG and indexing arenas." By enabling investors to use ESG criteria as a complementary tool, he believes that passive funds will make it easier "to incorporate one's values into a broadly diversified, cost- and tax-efficient asset allocation plan."
For another perspective on passive ESG strategies, see Marla Brill's "Sustainability Indexes: Pros and Cons" at FA Green.