May 2020

Environmental, Social, and Governance (ESG)-oriented ETFs took off in 2005 with the launch of the iShares MSCI USA ESG Select ETF, with a little over $20 million in assets. It took 14 years for ESG ETF assets to reach $5 billion, and just 18 more months to get to $25 billion. What happened?

Sustainable investing has been around for decades but it was initially focused on pockets of the investment ecosystem, did not have widespread adoption, and was mainly focused on strategies that excluded areas of the markets that didn’t align with the investors’ values. It was about five years ago that large institutional investors began to consider ESG, media coverage increased, and the growth of standardized ESG data contributed to the adoption of ESG into the investment mainstream. At that time, there were two main questions with regard to ESG investing:

First, will all the buzz around ESG result in asset flows?
Second, by adopting a sustainable investment strategy, does the investor forgo return relative to a conventional strategy?

In this Perspectives piece, we use ETF flow and performance data from the past 12 months to give clarity on flows into ESG investments, which have gained steam in 2020 and could be foreshadowing a tipping point for flows into ESG strategies. As an example, while ESG-oriented ETFs represent only 0.8% of the $6 trillion of U.S.-listed equity ETFs, they have accounted for over 30% of ETF inflows thus far in 2020!

We also highlight performance – an ESG strategy does not result in inferior returns versus a conventional index. In fact, over the past 12 months – in which we’ve seen equities make all-time highs as well as the fastest bear market in history — ESG strategies have largely outperformed the most popular conventional passive ETFs.

Ultimately, we believe the acceleration in flows into ESG ETF assets are a result of three factors: first, the continued trend toward values-based investing, which has been spurred further by the COVID-19 and oil crises this year. Second, the breadth of investment options has reached critical mass – the average investor now can access most public asset classes through ETFs. Lastly, investors have been able to observe the performance of ESG ETFs through historic bear and bull markets in the last three years alone, and the returns so far have been favorable to ESG strategies relative to conventional passive indexes and ETFs.

Fund Flows – The Hype is Real

The inflow of funds into ESG ETFs, primarily in equities, has picked up steam in the past 12 months to an AUM base of $25.2 billion as of April 30, 2020. Just to put that into perspective, it took ESG ETFs a little under two years to go from zero to $1 billion in assets, 12 more years to reach $5 billion in assets, and then just 18 months to reach a $25 billion AUM mark! The chart below shows the growth of ESG ETF assets over time.

The recent wave of asset flows has been concentrated in equities, which account for the bulk of the ETF equity flows thus far in 2020. The table below shows flows of ESG ETFs versus the larger ETF universe in both equities and fixed income. While ESG Equity ETFs represent 0.8% of total equity ETF assets, they have accounted for over 30% of all equity ETF flows thus far in 2020!

The ESG fixed income space tells a different story. In 2020, fixed income ESG ETF inflows have remained modest. We believe that the slower adoption of fixed income relative to equity ETFs is to be expected as the ETF market in fixed income is smaller in terms of assets and the number of ETFs. However, as ESG investing continues to pick up steam as we have seen in equities, we believe that most asset classes and fund types should benefit from this trend.

ESG Performance – Through Thick and Thin

Investors now have enough of a sample size to judge how ESG-oriented strategies perform in both euphoric bull markets and deep bear markets. The past three years in markets have alternated between a low volatility rally in 2017, a sharp drawdown in the fourth quarter of 2018, one of the best years for equity markets in 2019, and the fastest bear market in history in 1Q 2020 during the COVID-19 crisis. It truly has been an interesting “laboratory environment” for an investment strategy, and ESG thus far has shown robustness across different market environments.

In the tables below, we examine performance of the largest segment of ESG ETF assets, U.S. equities, versus the largest passive ETFs to gauge performance during those time periods. We found that ESG not only has kept up with conventional indexes, it has also been able to outperform, which we believe is a big reason for the recent inflows into the ESG category.

The table below displays the performance of some of the largest ESG Equity ETFs as well as the largest passive ETFs of conventional indexes in equities. On a YTD basis, the ESG ETFs have outperformed the largest S&P 500 ETFs, and even the Nuveen ESG Small Cap ETF, an ESG-oriented U.S. equity strategy, has outperformed the largest U.S. Small Cap ETF on a YTD and three-year basis.

In observing the recent performance of ESG strategies, investors are recognizing the advantages of a company with superior sustainability characteristics. A company that implements material ESG principles is often associated with properties of a “high-quality” company as defined in quantitative investing parlance: profitability, low volatility, and stable earnings. These properties of companies are rewarded by markets over time, especially during late-cycle environments and recessionary time periods.

A Sign of Things to Come – Growth Opportunities

In his bestselling book The Tipping Point, author Malcolm Gladwell defines a tipping point of a social trend as the following:

The tipping point is that magic moment when an idea, trend, or social behavior crosses a threshold, tips, and spreads like wildfire.

The discussion, anticipation, and importance of ESG over the past five years has seen a follow through in asset flows, and like many of the examples in Gladwell’s book, once a concept crosses the “threshold,” change happens rapidly, not gradually.

Sage is fully committed to the growth of ESG. We provide investors with ESG ETF models, an ESG corporate bond ETF (GUDB), and ESG fixed income strategies. As ESG remains a small fraction of the ETF and separate account markets, we see the most potential for growth in two main areas. First, ESG fixed income strategies, which are picking up flows but not to the scale of equity strategies, could see the same growth trajectory as equity ETF assets as fixed income funds continue to build a track record. Additionally, there is room for growth for ESG ETFs within the defined contribution space, where there is a dearth of ESG options in most 401(k) plans. With the millennial generation now becoming the largest investment cohort, the 401(k) choice architecture should evolve with the demographics and include more ESG strategies.

Disclosures: This is for informational purposes only and is not intended as investment advice or an offer or solicitation with respect to the purchase or sale of any security, strategy or investment product. Although the statements of fact, information, charts, analysis and data in this report have been obtained from, and are based upon, sources Sage believes to be reliable, we do not guarantee their accuracy, and the underlying information, data, figures and publicly available information has not been verified or audited for accuracy or completeness by Sage. Additionally, we do not represent that the information, data, analysis and charts are accurate or complete, and as such should not be relied upon as such. All results included in this report constitute Sage’s opinions as of the date of this report and are subject to change without notice due to various factors, such as market conditions. Investors should make their own decisions on investment strategies based on their specific investment objectives and financial circumstances. All investments contain risk and may lose value. Past performance is not a guarantee of future results.

Sage Advisory Services, Ltd. Co. is a registered investment adviser that provides investment management services for a variety of institutions and high net worth individuals. For additional information on Sage and its investment management services, please view our web site at www.sageadvisory.com, or refer to our Form ADV, which is available upon request by calling 512.327.5530.

The N95 mask has become a symbol of the fight against COVID-19. Named for its ability to block 95% of airborne particles, it has become vitally important to protect health care workers fighting deadly viruses. In the wake of the COVID-19 pandemic, N95 masks are in dangerously short supply. Skyrocketing demand and diminishing supply have left health care providers caring for ill patients without protective personal equipment (PPE), such as the N95 masks, gloves, and surgical gowns. Many have reported being forced to ration or reuse PPE. Medical staff have even taken to social media to communicate the intensity of the situation, making #GetMePPE a trending topic. It has been estimated that fighting COVID-19 will require 3.5 billion masks in the U.S. alone.

Earlier this year we published a perspectives piece on 3M’s chemical industry and its involvement with PFAS (per- and polyfluoroalkyl substances) contamination. We called attention to the company’s questionable business ethics that were brought to light when it failed to effectively manage PFAS, leading to a decades-long national health crisis. However, 3M’s chemical branch only makes up less than a third of its revenue. The company has a diverse business model and is also a large producer of medical equipment and supplies, bringing 3M’s name to a multitude of national headlines over these past weeks. While several companies make N95 masks, 3M has a near monopoly on production. Other respirators that work to block 95% of airborne particles exist, but the FDA has only approved N95s for use in the U.S., putting 3M in a unique position of great responsibility.

Mark Cuban, owner of the Dallas Mavericks, has become an unlikely voice in advocating against PPE price gouging. When Cuban began digging into the N95 market, his goal was to get hospital workers the protective equipment they need. Instead, he found his inbox flooded with emails from distributors reselling masks with significant price markups – a normal N95 mask costs anywhere from $0.50-$1 – Cuban was offered the masks at $8 each. 3M does not sell its masks directly to consumers, but rather uses licensed distributors as middlemen. While 3M has said it will not raise prices for medical equipment, a lack of supply, price consistency, and information have led to a free-for-all among companies wanting to resell the masks. This had led to extreme price gouging, with masks being sold at highly inflated prices – like the ones offered to Mark Cuban. State governors across the U.S. have reported being forced to partake in bidding wars for N95 masks, allowing states that can afford to pay the premium to take home the order.

When asked about distributor price gouging, a representative for 3M has said the company cannot control prices retailers and dealers charge for 3M products. A statement released by the company’s CEO Mike Roman promises that 3M will be working with federal and state governments to prevent price gouging and counterfeiting. Already, 3M has filed multiple lawsuits against those it has found profiteering; however, we find this situation reminiscent of 3M’s management of PFAS; the company has exhibited a stark lack of transparency and has failed to be proactive.

In normal circumstances, there is no reason 3M should not maintain its relationships with mask distributors – but these are not normal times. We believe 3M could have easily required distributors to sell directly to hospitals and health care providers, while threatening to end contracts with distributors who refused. 3M chose not to do so. Instead, for weeks the company sat on the sidelines while distributors increased prices and American health care providers went without PPE.

In late March, the Trump Administration invoked the Defense Production Act after it discovered that 3M was still exporting masks to Canada and Latin America. After determining that cutting off mask supplies to other countries would prove detrimental to the United States, 3M and the White House announced that the company will import 166.5 million respirators to the U.S. over the next three months while also continuing to fulfill foreign contracts. While the agreement was amicable, President Trump’s initial public frustration with 3M hurt the company’s brand image and could have been avoided if 3M had chosen to better communicate with the country about what is happening in the N95 mask market.

Beyond Scotchgard and Command Strips, 3M’s participation in the health care industry means the company has a duty to serve its stakeholders during this time to increase production of medical equipment and supplies and prevent price gouging and counterfeiting. 3M has worked to increase N95 capacity, but supply has not met demand and the company has not done enough to effectively combat price gouging. Lack of communication has led to wasted resources and time. We believe the company’s lack of transparency reinforces our view that 3M’s weak corporate governance presents material ESG risks that are unlikely to abate anytime soon.

Timeline of 3M’s Missteps

Month: May 2020

A Tipping Point in ESG ETFs?

Company Transparency in the Time of COVID-19: An Update on 3M’s Missteps