Passive ESG investing is on the rise. And with good reason. The performance myth is fading as more and more ESG indexes across asset classes demonstrate better or competitive returns versus their non-ESG equivalents.1
The international asset class is no exception. The MSCI EAFE ESG Leaders Index has outperformed the MSCI EAFE Index since its inception on October 1, 2007 for the period ending September 30, 2017, and has done so with less risk.
This article seeks to uncover the impact ESG factors have on non-U.S. developed markets performance. Specifically, does the bias to companies with better ESG profiles improve performance? To address that question we looked at the performance attribution of the Pax MSCI EAFE ESG Leaders Index Fund, which tracks the performance of the MSCI EAFE ESG Leaders Index.
The MSCI EAFE ESG Leaders Index consists of equity securities with favorable ESG ratings in developed markets excluding the U.S. and Canada, as rated by MSCI. As an index-based strategy, the Fund is designed to consistently capture ESG as a driver of risk and return, while providing clients with a broadly diversified portfolio by sector and region.
Figure 1 illustrates the long-term results that the Fund has achieved, delivering better returns than the EAFE Index with lower risk. Since the Fund’s inception on January 27, 2011, it has delivered a return of 5.33% with a standard deviation of 13.35 vs. the EAFE Index return of 5.14% with a standard deviation of 13.99. The Fund also significantly outperformed its Lipper international peer group average, which returned only 4.55% with a higher standard deviation of 13.55.
Figure 1: Return Chart – Since Inception 1/27/2011 as of 9/30/2017
View fund performance here.
Given that the key differentiator of the Fund relative to EAFE is its focus on companies with higher ESG scores, a closer examination of its performance provides insights into the key role that ESG factors have played in the strong performance.
The MSCI Intangible Value Assessment (IVA) rating, which ranks companies’ overall ESG profiles relative to peers on a seven-point scale from AAA to CCC, is a key factor in the EAFE ESG Leaders Index and therefore the Fund’s stock selection process. The rating expresses how well a company manages its most material ESG risks and opportunities. Each company in the EAFE ESG Leaders Index has been assigned an IVA rating by MSCI ESG Research.
To better understand the ESG profile of the Fund and examine the ESG contribution to performance relative to the EAFE, we delineated the Fund’s holdings into the three IVA tiers:
Figure 2 depicts the weight of each of the IVA tiers and their contribution to performance since inception. The Fund’s Top Tier allocation has averaged 76% since inception compared to the EAFE Index’s allocation of 56%. The Fund has averaged a lower allocation to both the average and lowest rated companies relative to EAFE. The large overweight to Top Tier companies had the largest positive contribution to relative performance, providing further evidence of ESG factors’ materiality on performance since the Fund’s inception. We are encouraged by the positive contribution that strong ESG companies have made to performance.
Middle Tier companies also contributed positively to performance, with benefits attributable to both the underweight to Middle Tier companies and stock selection among this group. The Bottom Tier companies had a negative and negligible impact on relative performance.
Figure 2: IVA Allocation and Attribution – Inception 1/27/2011 as of 9/30/2017
Attribution is based on daily gross holdings based results, which does not include fund expenses, trading costs and etc. The total cumulative gross return for the fund was 52.21% vs. 39.55% for MSCI EAFE. Other not rated securities and cash were excluded from both charts.
When we review attribution results at the sector level, 8 out the 11 sectors provided positive contribution to relative performance vs. the EAFE Index (see Figure 3 below). The relative contribution at the total fund level is 70% stock selection and 30% sector variation relative to EAFE. The sector contribution is largely due to the modest difference in sector weights between the Fund and EAFE (the active weight), with individual sector allocation impacts on relative return in a range of 1.12% to -0.32%.
When we drill down deeper, focusing on each sector’s underlying ESG performance impact utilizing the three tiers described above, we see that in 5 out the 8 positive contributing sectors the Top Tier group (which is made up of the highest-rated ESG companies) contributed the most to performance. Two sectors with negative relative contributions had the greatest negative contribution from Bottom Tier and Middle Tier companies.
Figure 3: Sectors as of 9/30/2017
|Sector||Active Weight (%)||Relative Contribution vs. EAFE (%)||Relative Contribution vs. IVA Tier|
|Health Care||1.36||1.79||Top Tier|
|Telecom. Services||0.72||1.48||Top Tier|
|Consumer Discretionary||0.73||1.29||Middle Tier|
|Information Technology||-0.24||0.05||Top Tier|
|Real Estate||-0.73||-0.00||Top Tier|
|Consumer Staples||-1.12||-1.79||Middle Tier|
Active weight is the difference in sector weights between the Fund and EAFE.
IVA Tiers: Top Tier – AAA/AA/A rated companies – highest rated companies, Middle Tier – BBB/BB rated companies – average rated companies and Bottom Tier – B/CCC rated companies – lowest rated companies.
Attribution is based on daily gross holdings based results, which does not include fund expenses, trading costs, etc. The total cumulative gross return for the fund was 52.21% vs, 39.55% for MSCI EAFE. Other not rated securities and cash were excluded from both tables.
As mentioned earlier, the Fund’s volatility, as measured by standard deviation, has been lower than the MSCI EAFE Index. Figure 4 provides another perspective on risk using the downside capture ratio, a measure of how a portfolio performs in down markets. Since inception the Fund produced a 95% downside capture ratio, better preserving value during down markets relative to the EAFE Index and Lipper peers. These risk statistics provide support for the growing belief among investors that integration of ESG factors may help reduce risk.2
Figure 4: Downside Capture – Since Inception 1/27/2011 as of 9/30/2017
We are encouraged that for the since inception period, the Fund has delivered higher returns with lower risk than the EAFE Index. We are particularly encouraged by the contribution of the companies with high ESG ratings, which had a positive impact on relative performance over this period at the aggregate fund level and in the majority of the underlying sectors. This deeper look into performance supports the notion that ESG factors can help international equity portfolios deliver potentially stronger performance with lower risk over time.
1 Morningstar recently reported that sixteen of the 20 equity indexes in Morningstar’s Global Sustainability Index Family have outperformed their non-ESG equivalent over their life span. Source: Does Investing Sustainably Mean Sacrificing Return? Morningstar, October 2017.
2 Callan in a 2013 piece entitled “Are U.S. Investors Warming Up to ESG?”, found 60% of survey respondents believe by incorporating ESG factors they expect to achieve better risk-adjusted returns over the long run. Mercer in a March 24, 2015 press release highlighted results of a survey they performed which showed that 57% of respondents believe that incorporating ESG criteria has a positive impact on risk adjusted returns.
†The MSCI EAFE ESG Leaders (Net) Index is designed to measure the performance of equity securities of issuers organized or operating in Europe, Australasia and the Far East that have high environmental, social and governance (ESG) ratings relative to their sector and industry group peers, as rated by MSCI ESG Research annually. The MSCI EAFE ESG Index includes or utilizes data, ratings, analysis, reports, analytics or other information or materials from MSCI’s ESG Research Group within Institutional Shareholder Services Inc., an indirect wholly-owned subsidiary of MSCI. Performance for the MSCI EAFE ESG Leaders Index is shown “net,” which includes dividend reinvestments after deduction of foreign withholding tax. One cannot invest directly in an index.
xThe MSCI EAFE (Europe, Australasia, Far East) (Net) Index is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of the following 21 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom. Performance for the MSCI EAFE Index is shown “net,” which includes dividend reinvestments after deduction of foreign withholding tax. One cannot invest directly in an index.
‡Lipper International Large-Cap Core classification tracks the results of funds that, by portfolio practice, invest at least 75% of their equity assets in companies strictly outside of the U.S. with market capitalizations (on a three-year weighted basis) above Lipper’s international large-cap floor. International large-cap core funds typically have an average price-to-cash flow ratio, price-to-book ratio, and three-year sales-per-share growth value compared to their large-cap specific subset of the S&P/Citigroup World ex-U.S. BMI. This classification includes both ETFs and active retail mutual funds. Lipper International Large-Cap Core Average is the average return of the entire Lipper International Large-Cap Core classification. One cannot invest directly in index.
Price-to-cash flow ratio represents the amount an investor is willing to pay for a dollar generated from a particular company’s operations. It shows the ability of a business to generate cash and act as a gauge of liquidity and solvency.
Price-to-book ratio represents equity securities within the Fund’s portfolio, and is not intended to demonstrate Fund growth, income earned by the Fund, or distributions made by the Fund.
Sales-per-share growth is a ratio that computes the total revenue earned per share over a 12-month period. It is calculated by dividing total revenue earned in a fiscal year by the weighted average of shares outstanding for that fiscal year.
Standard Deviation measures a Fund’s variation around its mean performance; a high standard deviation implies greater volatility.
Downside capture – measures an investment manager’s overall performance in down-markets and is used to evaluate how well or poorly an investment manager performed relative to an index during periods when that index has dropped. A downside capture ratio less than 100 indicates that the investment manager has outperformed its index during down-markets, while downside capture ratio greater than 100 indicates that the investment manager has underperformed its index during down-markets.
Tracking Error: A divergence between the price behavior of Fund and the price behavior of a benchmark.
MSCI ESG Research evaluates companies’ ESG characteristics and derives corresponding ESG scores and ratings. Companies are ranked by ESG score against their sector peers to determine their eligibility for the MSCI ESG indices. MSCI ESG Research identifies the highest-rated companies in each peer group to meet the float-adjusted market capitalization sector targets. The rating system is based on general and industry-specific ESG criteria, assigning ratings on a 7-point scale from AAA (highest) to CCC (lowest).
The returns* for the Pax MSCI EAFE ESG Leaders Index Fund – Institutional Class (PXNIX) as of 9/30/2017 were: 1 year: 16.46%,
3 year: 4.82%, 5 year: 8.33%, Inception (01/27/2011): 5.33%.
The returns* for the Pax MSCI EAFE ESG Leaders Index Fund – Institutional Class (PXNIX) as of 10/31/2017 were: 1 year: 21.67%,
3 year: 5.40%, 5 year: 8.62%, Inception (01/27/2011): 5.48%.
Performance data quoted represent past performance, which does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. For most recent month-end performance information visit paxworld.com.
*Figures include reinvested dividends, capital gains distributions, and changes in principal value.
As of 5/1/17 prospectus, total annual Pax MSCI EAFE ESG Leaders Index Fund operating expenses, gross of any fee waivers or
reimbursements, for Individual Investor Class and Institutional Class shares are 0.80% and 0.55%, respectively.
The Fund does not take defensive positions in declining markets. The Fund’s performance would likely be adversely affected by a decline in the Index. Equity investments are subject to market fluctuations, the fund’s share price can fall because of weakness in the broad market, a particular industry, or specific holdings. Emerging markets and International investments involve risk of capital loss from unfavorable fluctuations in currency values, differences in generally accepted accounting principles, economic or political instability in other nations or increased volatility and lower trading volume. Investments in Asia/Pacific increase the impact of events and developments associated with the region can adversely affect performance.