The megatrends underlying the transition to a more sustainable economy, such as climate change and widening inequality, are global issues. It should come as no surprise, then, that companies are addressing sustainability risks and opportunities regardless of their domicile.
So investors may be wondering, how are companies in developed markets outside the U.S. and Canada performing on sustainability issues? It varies, of course, but on the whole, they are performing better than those in the U.S.
In this article we take a closer look at this ESG quality phenomenon and share other takeaways about risk and performance from our experience managing the Pax MSCI EAFE ESG Leaders Index Fund — and its predecessor based on the same index — since 2011. The Fund uses an index-based strategy that seeks to track the performance of the MSCI EAFE ESG Leaders Index, consisting of equity securities with favorable ESG ratings in developed markets outside the U.S. and Canada.
First, it should be noted that investors gain a built-in sustainability boost simply by investing in non-U.S. developed markets, even before applying an ESG-integrated investment approach. As shown in Figure 1, below, the ESG research score (IVA rating1) of the MSCI EAFE Index, which measures the equity market performance of developed markets outside the U.S. and Canada, is better than that of the MSCI USA Index, which measures the performance of large and mid-cap segments of the U.S. market.
Figure 1 also shows that investors can build on that MSCI EAFE Index sustainability advantage by focusing on companies that have the highest-rated ESG performance in each sector, which is the methodology behind the MSCI EAFE ESG Leaders Index. Correspondingly, we can see the same pattern in controversy scores and carbon intensity data for all three indexes.
Figure 1: Improved Sustainability Outcomes from Non-U.S. Developed Market and ESG Focus
Source: Impax Asset Management. Data from MSCI and Factset as of 9/30/19.
So, why do companies in the MSCI EAFE Index demonstrate stronger ESG characteristics than the MSCI USA Index, on average? It’s a two-part explanation: 1) the MSCI EAFE Index has a greater proportion of top-tier ESG leaders that are concentrated in the European2 region, and 2) the MSCI USA Index ESG quality score gets dragged down by a greater proportion of companies that lag on ESG measures.
First, let’s consider European ESG leadership. We believe that stricter European regulations and a stronger cultural awareness of ESG issues, particularly environmental matters, have resulted in company profiles that rate higher on ESG than in regions where perhaps a sustainability mindset is less established and where there is less required reporting of ESG-related data.
An important distinction, however, is that all European countries are not the same when it comes to ESG strengths. For instance, German companies tend to be more ESG-savvy than Israeli or Italian companies, and there is a much larger weight in the MSCI EAFE Index toward German companies than to those in Israel or Italy.
Still, on average, the 14 countries that make up the MSCI EAFE “Europe” classification, which includes Israel, have better ESG scores than other regions represented in that index, including Australia, Hong Kong, Japan, New Zealand and Singapore.
Meanwhile, the U.S. has a greater allocation of ESG laggards, which we believe is primarily reflective of the country’s highly diversified economy. ESG laggards in the MSCI USA Index represent many industries; however, there are notable concentrations in the ESG-challenged pharmaceuticals, automotive and energy areas of the market.
In our view, U.S. investors with a home country preference can take a step toward improving the sustainability profile of their portfolios by incorporating an international developed markets allocation.
ESG integration is now widely recognized as a strategy for mitigating risk,3 and in our experience that certainly applies to non-U.S. developed markets.
As illustrated in Figure 2, the Pax MSCI EAFE ESG Leaders Index Fund, which tracks the performance of the MSCI EAFE ESG Leaders Index, has experienced -4% less volatility and -4% less downside risk than the MSCI EAFE Index since its inception, as of 9/30/19. These risk statistics provide support for the growing body of research that finds integration of ESG factors is correlated with reduced risk.4
Figure 2: ESG Risk Mitigation Benefits
Source: Impax Asset Management, MSCI and Factset. PXNIX Inception (1/27/11) through 9/30/19. Past performance does not guarantee future results. Pax MSCI EAFE ESG Leaders Index Fund Has Delivered Lower Volatility and Downside Risk than the MSCI EAFE Index, Since Inception 1/27/11 as of 9/30/19.
Since what differentiates the Pax MSCI EAFE ESG Leaders Index Fund from the MSCI EAFE Index 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 results.
Through performance attribution we have found that the bias to companies with stronger ESG profiles is, in fact, driving the excess return.
Figure 3 depicts the weight of each of the IVA tiers and their contribution to performance since inception. The large overweight to top-tier companies drove the greatest positive contribution to relative performance since the Fund’s inception, providing further evidence of ESG factors’ materiality on performance.
Figure 3: Excess Return Driven by Top-tier ESG Companies
Source: Impax Asset Management, MSCI and Factset. IVA Allocation and Attribution – Inception (1/27/11) through 9/30/19. Attribution is based on daily gross holdings-based results, which does not include fund expenses and trading costs, etc. The total cumulative gross return for the fund was 57.52% vs. 41.42% for MSCI EAFE. Other not-rated securities and cash were excluded from both charts. Past performance does not guarantee future results.
For long-term investors, the case for an international equity allocation isn’t a “why now” argument, it’s timeless. In our view, the same holds true for international sustainable investing. As we’ve witnessed through managing the Pax MSCI EAFE ESG Leaders Index Fund these past eight years, international developed markets with a focus on highly rated ESG leaders can provide high ESG quality as well as competitive risk-adjusted performance. This presents a fine opportunity for U.S. investors to look eastward for a sustainability advantage that can provide diversified international equity exposure.
For additional information on the Fund, including holdings and country allocation, visit the Fund’s web page.
1 MSCI ESG Intangible Value Assessment (IVA) provides research, ratings, and analysis of companies’ financially material risks and opportunities arising from environmental, social and governance factors. Companies are rated by MSCI ESG analysts on a seven-point scale of ‘AAA- CCC’ relative to the standards and performance of their industry peers. The MSCI ESG IVA ratings provide a signal to investors of the extent to which a company is well‑positioned to manage the financially material risks and opportunities arising from key ESG trends.
2 Europe, in the MSCI EAFE Index classification, includes Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Israel, Italy, Netherlands, Portugal, Spain, Sweden, Switzerland and the United Kingdom.
3 Julie Gorte, “The Business Case for Sustainability,” Impax Asset Management, July 10, 2019, https://paxworld.com/the-business-case-for-sustainability/
The MSCI EAFE ESG Leaders 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 ESG ratings relative to their peers as rated by MSCI ESG Research annually.
The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada. The MSCI EAFE Index consists of the following 21 developed market country indexes: 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.
One cannot invest directly in an index.
Standard Deviation measures a Fund’s variation around its mean performance; a high standard deviation implies greater volatility.
Downside Capture is a statistical measure of an investment manager’s overall performance in down-markets.
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 10/31/2019 were: 1 year: -0.30%, 3 year: 5.83%, 5 year: 3.23%, Since Inception (01/27/2011): 4.28%. The returns for the Pax MSCI EAFE ESG Leaders Index Fund – Investor Class (PXINX) as of 10/31/2019 were: 1 year: -0.57%, 3 year: 5.60%, 5 year: 2.96%, Since Inception (01/27/2011): 4.02%. The returns for the MSCI EAFE Index as of 10/31/2019 were: 1 year: -1.34%, 3 year: 6.48%, 5 year: 3.27%, Since Inception (01/27/2011): 4.09%.
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.
Total annual Pax MSCI EAFE ESG Leaders Index Fund operating expenses, gross of any fee waivers or reimbursements, for Institutional Class and Individual Investor Class shares are 0.55% and 0.80% as of 5/1/2019 prospectus. The management fee is a unified fee that includes all of the operating costs and expenses of the Fund (other than taxes, charges of governmental agencies, interest, brokerage commissions incurred in connection with portfolio transactions, distribution and/or service fees payable under a plan pursuant to Rule 12b-1 under the Investment Company Act of 1940 and extraordinary expenses), including accounting expenses, administrator, transfer agent and custodian fees, Fund legal fees and other expenses. (For this purpose, Impax Asset Management LLC does not consider acquired fund fees and expenses to be operating costs and expenses of the Fund.)
Note About Inception Date: On 3/31/2014 Pax World International Fund and Pax MSCI EAFE ESG Index ETF merged into the Pax MSCI EAFE ESG Leaders Index Fund (the Fund), a passively managed index fund which seeks investment returns that closely correspond to the price and yield performance, before fees and expenses, of the MSCI EAFE ESG Index. Based on the similarity of the Fund to Pax MSCI EAFE ESG Index ETF, Pax MSCI EAFE ESG Index ETF (the Predecessor Fund) is treated as the survivor of the mergers for accounting and performance reporting purposes. Accordingly, all performance and other information shown for the Fund for periods prior to 3/31/2014 is that of the Predecessor Fund. Inception date for Institutional Class shares is that of the Predecessor Fund, January 27, 2011. Inception date of Investor Class is March 31, 2014. The returns shown for Investor Class shares for periods prior to March 31, 2014 are those of the Predecessor Fund. These returns have been adjusted to reflect the expenses allocable to Investor Class shares.
RISKS: 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.
Investments involve risk, including potential loss of principal. You should consider Pax World Funds’ investment objectives, risks, and charges and expenses carefully before investing. For this and other important information, please download a fund prospectus. Please read it carefully before investing.
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