Two years ago, as more research on sustainable investing began to appear and the number of environmental, social, and governance-focused investment options continued to grow, we began asking ourselves a question at our firm: What if we integrated ESG-focused mutual funds into all our client portfolios?
ESG Should Mean Less Risk
For us here at R&A, the transition to ESG wasn’t a marketing gimmick, nor was it simply a reflection of the troubled world we live in and a desire to make a difference. Essentially, we wanted to know if we could produce better results for our clients using ESG. On an instinctive level, companies adequately considering ESG factors should be subject to less business risk and thus would produce better risk-adjusted returns over time. But, did this hold true?
Using analysis tools, we constructed comparable portfolios with and without an ESG focus. In the end, the ESG-focused funds had a better performance and risk profile, despite slightly higher expense ratios, than did the traditional model portfolios. For example, using our 60% equity/40% fixed-income model as a proxy, the ESG portfolio’s five-year annualized standard deviation (risk) was reduced to 6.16 from 6.69. The expected return was also higher (5.99% versus 5.84% annualized over the past five years through Nov. 30, 2019).
Thus, our analysis backed up our intuition.
Why Switch to ESG Now?
ESG investing is not just a trend. It is becoming more and more important to investors as they want to align their portfolios with certain standards. And, now is a perfect time to jump in because ESG factors can be objectively measured and there are numerous ESG-mandated funds that have accumulated long-term track records.
Factors to Consider
It is important to choose funds that have an ESG mandate rather than funds that just happen to score well on ESG measurements. Why? Because an ESG-mandated fund will continue to hold only those companies who pass ESG screens.
Fees must also be considered in relation to the risk/return benefits of ESG investing. Certainly, returns are reduced when mutual fund expenses increase. ESG funds, by nature, are active funds that require a deeper, more specialized bench of analysts. This makes these funds more expensive. However, by carefully selecting top ESG funds with reasonably low costs, we were able to create models with expense ratios that were only about 13 basis points greater than our old models. This translates to an extra $13 per $10,000 investment, which we believe is a small price to pay for the reduction in risk (and increase in return).
Today, our newest clients are automatically invested in a portfolio featuring ESG funds. From day one, they’ll get the benefit of knowing that their portfolio is better aligned with meeting their financial goals while aiming for greater good in the world.
Real Life Example
I recently attended a film festival where I saw the documentary “Maxima.” This 2019 film documents the struggle of a Peruvian woman in her efforts to protect her land from the encroachment of a large mining company.
After razing a huge territory in the Andes for gold, in 1995, the Yanococha mining company looked to expand its operations into an area that included land owned by Maxima Acuna. With a legal deed in hand, a concern for her family’s lifestyle and fear of the environmental impact on area communities, Maxima refused to leave – even as bulldozers approached. Due to corporate “deals” with local authorities, Maxima was arrested for squatting on her own land after suffering beatings and the destruction of her home. A Peruvian police officer told Maxima, “You’re an ant. The mining company is an elephant.” Unfortunately, the saga continues to this day as Yanococha steadfastly ignores court orders while harassing Maxima and her family.
The Yanococha mining company is owned by Newmont Mining – the only mining company listed on the S&P 500. (The World Bank held a minority interest but divested once this controversy came to light.) In my opinion, a company with environmental and governance issues like these surely presents an economic risk to all stakeholders, including its shareholders.
So, after viewing this film, I wanted to find out if the ESG funds we were using on behalf of clients held any Newmont Mining stock. The answer was no! Good news! What funds hold the largest stake of Newmont Mining? These would be index funds and ETFs such as Vanguard Total Stock Market Index, Vanguard Mid Cap Index, SPDR S&P 500 ETF Trust, Fidelity 500 Index, etc.
When considering investments and wishing to limit investor risk, an ESG mandate seems to make a lot of sense. Here we see an example of one company that, absent an ESG focus, would be held by our clients. Whether or not morality is a consideration, eliminating a company like this can be a big benefit to investors.