Trade-offs: High Level ESG Scores vs Specific Tilts

6/27/2018: IMPORTANT UPDATE AND CORRECTION TO THE BELOW HAS BEEN POSTED HERE: http://thoughtfulfinance.com/2018/06/27/update-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:

Source: Bloomberg, FossilFreeFunds.org

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

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.