There are myriad reasons justifying the extraordinary outperformance of FAANG (Facebook, Apple, Amazon, Netflix, Google) stocks in 2017 - 49% avg stock upside, compared to S&P500's +20% increase - and as we go into 2018, the sustainability of this stellar bull run is understandably being questioned. Should a correction transpire, this would cause systemic pain as these stocks have become top holdings of most global equity funds (not to mention almost all US centric funds). One thing of note for us here at OurConservatory, however, is that they are also consensus top holdings for ESG investors. Family offices who pressure impact investing often allocate portfolios between ESG funds in public securities alongside private impact projects, for risk and portfolio management purposes.
For new entrants into ESG investing, the oldest established format is Sustainable and Responsible Investing (SRI) funds. These range in degrees of sophistication, but all underpinned by the collective goal of aligning investment allocation with environmental, social and governance considerations. In the US and Europe, rating agencies have developed ESG ratings - much like credit ratings - which investors can incorporate into their process. Although the leading edge of this development has moved on to positive investing - strategies such as investing solely in ESG leaders, or in ESG "momentum" i.e. companies with improving ratings over time, here in Asia the space is still nascent, and it is not uncommon for people to marry "negative screening" (taking out ESG offenders, on a do-no-harm principle) and shareholder activism (more common for governance purposes) as the main SRI strategy.
These approaches enable scale and accessibility, both of which are crucial in providing an avenue for established investors to incorporate ESG principles into their traditional investment process. But I would like to discuss two problems here - firstly, one that concerns market capitalisation based indices, which applies universally (SRI or otherwise); and secondly, with the sometimes reactive nature of ESG ratings. Both of these are apparent when considering FAANG in an ESG context.
For illustration, the iShares MSCI KLD 400 Social ETF (ticker: DSI) is the largest single ETF by AUM ($1,033m) on ETFdb, and their holdings in Facebook, Alphabet (Google) and Netflix combine to 10.5%. Alphabet (combining Class A+ C) is their top holding, making up 5.87% of its investments, and overall, 32% of the fund is in Technology stocks. The ETF tracks a "float-adjusted market capitalization index designed to measure the equity performance of U.S. companies that have positive environmental, social, and governance characteristics.", and is one of the oldest "tools" for SRI - the underlying index has been in existence since May 1990, ranks "High" on the Morningstar sustainability rating, and with performance that matches the broader MSCI index, this ETF has been used by proponents of SRI to prove that incorporating their principles would not compromise return. It is also a negative screening ETF.
As mentioned at the beginning of this post, part of this Tech dependence has to do with how well the sector has done - this is the first problem, that with market capitalisation based indices. Strong stock performance perpetuates a virtuous cycle of further demand for the stock, as its weight in the index rises to catch up. Tech stocks now make up 33% of the S&P500 index, and the high weighting is reflected in all related indices. So, an investor hoping to build up SRI presence through an ETF would likely end up having the majority of their investment in Tech. But does this make sense?
This leads to the second issue. The methodology of rating agencies have vastly improved over time, but to some extent remains reactive. In truth, ESG definitions and priorities are evolving at such a rapid pace that it is difficult to be preemptive. But Facebook has fake news. Google has antitrust issues. Both may have questionable diversity employment policies. These concerns are well flagged on front-page news headlines - how long would these take to filter through to the Markets section? As an example of investors who are taking matters into their own hands, Apple is now facing pressure from large shareholders to address children's iPhone use. Shareholder activism is not new, but pushing social agendas as a financial investor is (also see my other blog post today on the broadening scope of impact investing).
With the rapid development of impact investing, the demand for a more holistic approach in assessing both impact and investment returns is outpacing traditional intermediaries' ability to facilitate. The two issues highlighted in this post are just examples of how current solutions - which will remain important given its easy accessibility and scalability - remain on the back foot. Technological improvements and regulatory changes are driving rising disintermediation and disrupting banks' dominance in investing, and these may well prove to be essential developments in allowing impact investing to go mainstream. The traditional investment management space should take note. As disruptive forces are challenging their bread and butter businesses, an innovative impact investment strategy may well prove to differentiate firms' longer term relevance in the coming decade.