As investors consider more ways to build up and diversify their portfolios, consider environmental, social and governance exchange traded funds (ETFs) that combine an integrated approach to ESG best practices with enhanced risk-adjusted return potential.
For example, joining the new wave of ETF products based on ESG principles, FlexShares has come out with 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 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.
“We believe measuring the impact of KPIs on security performance provides a holistic and diversified approach to ESG investing. Specifically, KPI integration improves bottoms-up security selection while removing data-provider bias. 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,” according to a Northern Trust FlexShares research note.
Related: ESG ETFs Could Find Support from Institutional Investors
FlexShares outlines seven distinct approaches to ESG-related investing currently floating around in the investment community: Negative/exclusion exclude specific securities based on ESG criteria. Positive/best-in-class target positive ESG performance relative to industry peers. Impact investing aim at solving social or environmental problems. Sustainability themed investing selects assets related to sustainability in single- or multi-themed funds. Corporate engagement and shareholder action use shareholder power to influence corporate behavior. Norms-based screenings hone in on investments against minimum standards of business practices based on international norms. Lastly, ESG integration seen as a systematic and explicit inclusion by investment managers of ESG risks and opportunities into traditional financial analysis.
“FlexShares gravitated towards a hypothesis that the best way to innovate in the ESG space is to integrate ESG-related KPIs into an investment strategy. A basic way to do this is to identify the materiality of each key performance indicator. Ideally, material KPIs would significantly impact risk/return with strong predictability,” according to the FlexShares note.
For instance, these key performance indicators may include factors like electricity use, NOx emissions, fatalities per 1,000 employees, community spending, classified board system and size of board, among others. The impact of these KPIs are then evaluated on a sector-by-sector basis since no two sectors are alike and each come with their own idiosyncratic strengths and weaknesses.
For more information on ESG-related investments, visit our socially responsible ETFs category.