By Chris Huemmer, Senior Investment Strategist at FlexShares ETFs.

Chris Huemmer, Senior Investment Strategist at FlexShares ETFs.

Many of today’s investors, especially millennials and gen-Xers, we believe are deeply concerned about the social impact of their investments.

In an effort to enable these individuals to align their investments with their values, many investment firms have launched funds that take into account environmental, social and governance (ESG) factors when choosing in what companies to invest. As of 31 January 2019, there were 210 ESG ETFs worldwide, representing $24.7 billion in assets, versus just 39 such ETFs and $5 billion ten years ago.

While there’s been a clear uptick in ESG ETF interest, there remains a lack of consensus as to how to define or apply ESG criteria and, as such, ETFs that focus on ESG take a variety of different approaches.

These strategies range from negative screening or exclusion, which filters out certain businesses or industries from investment consideration due to perceived negative social or environmental impact, to the positive or “best-in-class” approach, in which investment firms take an active role in determining which companies in a particular sector best meet ESG criteria. We believe there are benefits to a “core” approach (see below) utilizing an integrated methodology.

Source: FlexShares.

Advantages of ESG integration

An integrated ESG methodology, however, can encompass aspects of all the above approaches and incorporate the underlying principles, risks, and opportunities into a traditional financial evaluation framework. An integrated approach also puts an equal weight on each piece of ESG – i.e. valuing social issues such as workplace safety, labor relations, human rights, etc. as much as environmental considerations.

We believe an integrated method can help provide the optimal outcome for investors. It’s the underlying methodology behind FlexShares’ two ESG funds. The integration of environmental, social and governance factors enables flexibility when structuring client portfolios and offers a variety of potential advantages to investors, including:

• Materiality. A key component of ESG integration involves screening for just the material ESG issues that may affect security performance and investment outcomes.
• Portfolio tilts. The use of ESG integration can help with the identification of investment opportunities and enables investors to tilt their entire portfolio to securities that score well on ESG metrics, while potentially minimizing exposure to companies that score poorly on ESG metrics.
• Security selection. The use of ESG integration and investment screens provides the potential for identifying favorable investments during the security selection process that might not have otherwise been considered.
• Risk/Return profile. Integration uses ESG factors in an effort to manage investment risks and potentially improve long-term returns.

We think an integrated approach should provide a scalable and quantitative process which allows for targeted exposures to all three areas of ESG, while also focusing on companies that exhibit historically positive risk and return characteristics versus a typical market or cap-weighted approach.

FlexShares screens from an initial universe of companies represented by the STOXX Global 1800 Index, then uses publicly available data to evaluate each company based on 150+ key performance indicators (KPIs) having broad representation to the three distinct categories of criteria – environmental, social and governance.

An aggregate ESG score is determined for the eligible participants and the bottom 50% of companies are excluded from the index. The portfolio exposure is tilted in favor of constituents with higher aggregate scores in an effort to optimize risk-adjusted return.

FlexShares believes measuring the impact of KPIs on historical performance provides a potentially holistic and diversified approach to ESG investing. The methodology helps to build an ESG index by essentially coding at the “root” or company level versus applying an overlay or top-down ESG strategy; Our analysis suggests that it parallels the best behaviors of portfolio managers when it comes to evaluating, sorting and selecting companies for investment.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)