ETF Trends
ETF Trends

Investments and exchange traded funds based on environmental, social and governance, or ESG, principles have been attracting attention. But what exactly is ESG investing about?

ESG investing has been around for years, with large institutional investors dominating the early stages of ESG investment growth as they possessed the requisite expertise and governance protection of well-resourced investment committees, according to a FlexShares research note.

However, these same resources available to large institutions are not usually scalable for smaller investors. Consequently, index providers have recently looked to key performance indicators, or KPIs, reported by public companies in regulatory filings in an attempt to facility product development for retail investors.

“For example, a typical KPI for governance reporting is ‘percent of women on the board of directors’,” according to FlexShares. “Presently, more than 100 KPIs are reported that can be classified as fulfilling at least one environmental, social or governance theme.”

SEE MORE: Do ESG Strategies Benefit ETF Investors?

Other major KPIs that cover ESG principles include environmental indicators, like electricity use, NOx emissions, total water usage, energy intensity per employee and regulatory risk exposure, among others. Social indicators include points like fatalities per 1,000 employees, community spending, human rights policy, percentage of community spending on EBITDA and fatalities among contractors. Lastly, governance indicators include points such as classified board system, size of board, poison pill plans, unitary or two tier board systems and percent ownership required for special meetings.

Through these indicators, it is now possible for asset managers to develop and apply systematic investment strategies to evaluate a company’s risk and opportunities, according to FlexShares.

“Combining this type of information with traditional financial analysis and security selection is a textbook example of ESG integration,” FlexShares said.

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Investors may look at ESG investments as those that identify key indicators that would significantly impact the risk-to-return profile with a strong predictability. Some KPIs have exhibited significant impact on the long-term sustainability of a firm’s business model and share price performance while other indicators revealed weak or duplicative effects.

For example, joining the new wave of ETF products based on ESG principles, FlexShares recently launched the FlexShares STOXX US ESG Impact Index Fund (NasdaqGM: ESG) and FlexShares STOXX Global ESG Impact Index Fund (NasdaqGM: ESGG).

The funds are based on the STOXX global ESG Impact Index, which screens companies scoring better with respect to a select set of ESG key performance indicators (KPIs), with the bottom 50% of such companies based on their ESG KPI scores are excluded from the Index, as are companies that do not adhere to the UN Global compact principles, are involved in controversial weapons or are coal miners.

“KPI integration improves bottoms-up security selection while removing data-provider bias,” FlexShares added. “The methodology builds an ESG index by essentially coding at the ‘root’ level versus applying an overlay or top-down ESG strategy; it parallels the best behaviors of portfolio managers when it comes to evaluating, sorting and selecting companies for investment.”

For more information on ESG investment strategies, visit our socially responsible ETFs category.