Do Gun, Alcohol & Gambling Stocks Make the Cut in Your ETF?

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Exchange traded funds and other strategies that revolve around Economic, Social and Governance, or ESG, principles have been quickly gaining traction as investors and advisors incorporate the qualitative benefits of ESG investments into their portfolios.

However, some may question the up-and-coming theme as either a passing fad or a sustainable long-term strategy. So far, the ESG theme has outperformed in recent years.

According to FactSet data, the MSCI EAFE ESG Index has outperformed the benchmark MSCI EAFE Index by over 100 basis points for the past three years ended June 30, 2016.

"Diving deeper, we can see that this effect was driven predominantly by security selection effect," Ashley Fritz, Portfolio Analytics Specialist for FactSet, said in a note. "One might think that the avoidance of certain sectors would be the chief source of outperformance, but in reality, the companies with higher ESG scores simply performed better than their broad counterparts. Security selection added 91bps, while allocation only added 18bps during the three-year period analyzed."

Academic research has revealed that strong governance mechanisms have helped diminish default risk and lower bond yields. Barclays also discovered that investment-grade bonds with higher ESG scores outperformed those with low ESG scores over the past 8 years.

The ESG principle are more of a way of living or conducting business that correspond with a firm's core values. Many companies have defined their corporate social responsibility to account for their impact on the environment and social welfare even if there is no legal requirement.

With these socially responsible parameters, companies may be taking on a long-term business model. In an attempt to head off any environmental and social problems that their operations may create, companies are able to obviate potential regulations and diminish political risks ahead. Moreover, this proactive approach may diminish the risk of conflict with nongovernment organizations and other advocacy groups that can affect sales and brand recognition.

A reputation for social responsibility can also attract and retain talented individuals who are more apt to feel proud of their work.

Furthermore, with a new generation of investors, the younger demographics are more apt to favor companies that address social and environmental responsibilities. These investors will also be prone invest in companies that follow ESG principles as a way to align investment goals with their individual values and philosophies.

More recently, even large pension funds have banded together to pressure industries into fundamental changes. For instance, some large state pensions have dropped coal and energy companies in favor of more environmentally friendly investments. Pension funds have also pushed for changes in boardrooms and targeted governance problems in individual companies.

However, in the short-term, some observers may argue that companies could be intentionally setting input costs higher or incur a large upfront cost. For instance, some companies may acquire ingredients that have been Fairtrade certified, which provides farmers in emerging countries above-market prices to promote improved standard of living. Nevertheless, many consumers are willing to pay more for the products to feel better about the way a product was made.

Investors can target companies with a socially responsible mindset through ETFs, including the iShares MSCI USA ESG Select Social Index Fund (NYSE:KLD) and iShares MSCI KLD 400 Social ETF (NYSE:DSI), which provide broad exposure to companies with socially responsible characteristics.

KLD and DSI both include stocks with strong environmental, social, and governance records in areas that are relevant to their industries, including carbon emissions, labor management and corporate governance. KLD, though, excludes companies operating in the weapons, alcohol, gambling, nuclear power, adult entertainment and genetically modified organisms industries.

Retail investors interested in ESG investments can also look at the SPDR MSCI ACWI Low Carbon Target ETF (NYSE:LOWC) and the iShares MSCI ACWI Low Carbon Target ETF (NYSE:CRBN) for more socially responsible strategies. LOWC and CRBN both target the MSCI ACWI Low Carbon Target Index, which tries to address carbon exposure by overweighting companies with low carbon emissions relative to sales and per dollar of market capitalization, compared to the broader market. Both ETFs were created for the U.N. Joint Staff Pension Fund.

Fund providers have recently rolled out a number of ESG-based ETF strategies. For example, the iShares MSCI EAFE ESG Select ETF (NASDAQ:ESGD) and iShares MSCI EM ESG Select ETF (NASDAQ:ESGE), which track developed and emerging market companies with high ESG ratings, began trading at the end of June.

The Global X Conscious Companies ETF (NASDAQ:KRMA) tries to reflect the performance of the Concinnity Conscious Companies Index, which tracks companies that achieve financial performance in a sustainable and responsible manner and exhibit positive ESG characteristics.

Joining the new wave of ETF products based on ESG principles, FlexShares launched the FlexShares STOXX US ESG Impact Index Fund (NASDAQ:ESG) and FlexShares STOXX Global ESG Impact Index Fund (NASDAQ: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 are 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.

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