The past year has seen an explosion in the number of equity funds incorporating socially responsible criteria such as gender diversity or environmental sustainability into their investment selections. While most of these environmental, social and governance (ESG) funds have short track records, numerous research papers from data vendors, index providers and asset managers assert that on average such screens have no adverse impact on performance over time.
The problem? Investors buy a specific fund, not the average, and what little track record we have shows the spread on annual fund performance can run into the hundreds if not thousands of basis points. Our question: When will social responsibility hurt investors?
We turned to holdings-based analytics specialist Windfactor Research for an insight into how to be a good citizen and a good investor.
If we accept the research and assume good citizenship does not impact performance in and of itself, investors can evaluate socially responsible funds just like any others. For equity funds this means understanding the potential of the companies the fund has invested in given their relative prospects from the point of investment. For example, the iShares MSCI KLD 400 Social (DSI) and iShares MSCI USA ESG Select (SUSA) ETFs – two low tracking error ESG funds with long return histories – have both performed in line with the US market since 2013, but underperformed by a whopping 8% between 2010 and 2012.
What, then, will we see from these funds going forward? With fund Windfactors of 41 and 61 respectively and low best-match average returns, both are well positioned for relatively small tracking error versus our US benchmark over the next 12 months, with modest headwinds for DSI and slightly stronger tailwinds for SUSA.
An equity fund’s Windfactor is the statistical probability of the fund outperforming the US market over the next 12 months, expressed as a value ranging from 0 if it is the benchmark to 100 if outperformance is ‘historically certain’. Our research indicates that investing in funds with higher Windfactors would have been a good bet over the past decade and will continue to be so as long as history keeps on repeating itself.
Windfactors are derived from best-match returns, the average and volatility of historical one-year relative returns for similar companies during similar market environments. They leverage a unique business factor model that matches today’s companies with past firms based on criteria such as primary industry, earnings drivers, management policies and market value. Best-match returns are reported in percentages relative to the Windfactor US Market Portfolio.
Figure 1 shows the historical performance of DSI, SUSA and (for reference) the iShares S&P Total Market Index ETF (ITOT) alongside their current best-match statistics. Since DSI has underperformed SUSA over the past three years but has outperformed over the past 10, we conclude that analysis of relative historical performance is too dependent on the period examined to provide any reliable information. We instead look at the best-match returns for current fund holdings. Here we see SUSA is better positioned for the current market environment (1% versus -0.5%), although there has been enough volatility during similar periods (3.5% and 2.3% respectively) to suggest that next year could go either way.
Figure 2 shows the tilts toward specific business factors underlying the fund’s best-match returns. The analysis shows DSI allocates a higher percentage of fund assets toward firms with quality and/or small firm size at the expense of exposure to industry activity. Since industry exposure is relatively cheap in the current market and performance has historically been strong when comparably priced, the higher weight for SUSA translates into higher best-match returns for the fund.
Does this mean SUSA will make a good investor out of a good citizen? Not necessarily.
As with other quantitative tools, using Windfactors and best-match returns to forecast next year’s performance is a bet that history will repeat itself. But which part of history? The prospects for any fund in any given year are hardly certain. These analytics notwithstanding, new things can happen anytime with equities and changing business fundamentals can break past return patterns with lasting shifts in growth prospects. Following such events, one can only hope for a swift ‘return to normal,’ but even so it only stands to reason that good human judgment will remain a prerequisite for sustained outperformance.
Visit www.windfactor.com for additional research, test results and fund analysis.