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.