There are myriad benefits associated with stocks that score well on the basis of environmental, social, and governance (ESG) standards.
For example, many of these companies exhibit quality traits and lower volatility than their ESG laggard counterparts. What’s not to like about that? However, benefits and positive traits usually come with a cost, and that cost can be elevated valuations.
“For Low ESG Risk companies, investors are paying a 7% premium to fair value. At the other end of the spectrum, by contrast, the stocks of Severe and High ESG Risk companies trade for 16% and 8% discounts to fair value, respectively, and boast average star ratings above 3.0,” writes Morningstar analyst Haywood Kelly.
Although it’s not explicitly mentioned in the Morningstar note, one of the issues that investors contend with is the debate between broad ESG funds and exchange traded funds that focus explicitly on climate-aware or sustainability concepts. The Goldman Sachs Future Planet Equity ETF (GSFP ) resides in the latter category.
Many old guard ESG ETFs take broad market approaches that often lead to overweighting in the technology and communication services sectors, among others. That’s good from the perspective of being allocated to growth companies, many of which have quality tendencies.
However, that methodology, though it has benefits, isn’t perfect. For example, some companies might be good at one or two of the three ESG pillars, but not all three. Second, there’s the issue of large allocations to growth sectors pumping up a fund’s valuations, exposing investors to overvalued stocks in the process.
Conversely, the actively managed GSFP focuses on a specific area of the battle against climate change – eliminating or reducing greenhouse gas emissions — meaning its not at risk of being home to social or governance failures because the “E” in ESG is the fund’s point of emphasis.
Additionally, GSFP has something of a value tilt by allocating over 56% of its weight to industrial and materials stocks, while tech stocks represent 18.9% of the fund’s roster. GSFP’s value tendencies are particularly relevant at a time when some ESG leaders are richly valued.
“At some points in time, good ESG companies—however defined—will be relatively cheap as a group. At other times, as appears to be the case now assuming you believe our equity analysts, good ESG companies command a premium,” adds Kelly. “That’s why it’s dangerous to think there’s any one-to-one correspondence between ESG and investing returns that holds for all market environments. It all depends on relative valuations.”
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