One of the knocks on environmental, social and governance investing is that it’s a gray area. But it’s increasingly becoming more of a black-and-white thing as funds, index providers and research shops fine tune their methodologies to quantify the ESG concept.

And this isn’t just an academic argument because more investors—both institutional and retail—are aligning their capital with companies they believe are doing right by one or more of the "E," "S" and "G" principles. So they want to have confidence their money is doing what it’s supposed to do.

According to a recent Morningstar report, there were 392 U.S.-listed open-end mutual funds and exchange-traded funds tied to the ESG, or sustainable investing, theme as of year-end 2020. That was a 30% increase over the prior year and represented a fourfold increase during the past 10 years. The report noted that growth in this category kicked into a higher gear starting in 2015.

The report’s author, Jon Hale, writes that sustainable investing incorporates the full range of ESG concerns while aiming to improve both investment performance and societal outcomes.

Seventy-one such funds came to market last year, which blew away the prior record of 44 new sustainable funds in 2017. And sustainable funds garnered record inflows of $51.1 billion last year, or more than double the prior record set in 2019.

Regarding performance, Morningstar noted that three-quarters of sustainable equity funds last year finished in the top half of their investment category, and 43% generated top quartile returns. Meanwhile, just 6% languished in their category’s bottom quartile.

The TrueShares ESG Active Opportunities ETF (ECOZ) debuted last year and has produced solid performance results. The fund started trading in early March 2020, just in time for the Covid-related market crash. It quickly sank like a stone, but rebounded in the broad equity rally that followed and it sports a one-year return of 68%, placing it in the upper half of its Morningstar assigned large-blend category. Since inception, the fund is up 38%. Its benchmark, the S&P 500 Index, gained 30% during that period.

ECOZ is an actively managed product with a strong emphasis on carbon footprint. The fund is a collaboration between TrueMark Investments and Purview Investments. TrueMark sponsors the TruShares fund family comprising three active thematic ETFs and a suite of structured outcome ETFs. Purview is an independent investment management firm specializing in global investing and impact investing.

“We separated out carbon by itself because we view that as the most urgent issue [of the ESG principles], and we want to evaluate the carbon footprint that companies have,” said Jordan Waldrep, principal and chief investment officer at TrueMark Investments. “We have our own proprietary way of approaching this because we want to look at it from the lens of how we’re thinking about carbon intensity issues.”

He added that carbon emissions is an area that can be quantified with hard numbers.

“The other aspects are important, but they’re less quantifiable,” he said. “All of ESG is kind of shades of gray. There’s no perfect ESG company.”

Carbon Intensity
Waldrep handles the bottoms-up research on the financial side, while Purview CEO Linda Zhang is the primary go-to person on ESG aspects. Zhang digs into ESG-related data on companies provided by the likes of Bloomberg, Sustainalytics and MSCI, and looks at how individual companies report their carbon emissions data.

Waldrep noted the fund’s analysis starts with an industry level estimate for every industry in the S&P 500, and then it looks at individual companies and their carbon intensity scores and their reporting history.

“I’d say 65% to 70% of companies in the S&P 500 are reporting that data across a lot of industries,” he said. “You can combine that with revenue numbers to get a carbon intensity number, which has become an industry standard for getting comparable numbers to show how much carbon is generated by $1 million of revenue.”

The fund employs a process to come up with its own score on carbon intensity by handing out merits or demerits to a company’s carbon intensity rating based on patterns in a company’s emissions history, as well as on the frequency of their reporting.

“If they’ve been reporting regularly, say in four of the past five years, that’s a good number to get an estimate of the carbon intensity they have,” Waldrep explained. “We look at the slope of their carbon footprint, and if their slope is negative that means they’re improving. So we give them a little boost with a 5% reduction in their estimated number. (A lower score is better.) And we penalize them by adding 5% if the slope is positive.

“This emphasizes the companies making the right steps and de-emphasizes the companies that are making the wrong steps,” he continued.

Companies with less reporting history on their carbon footprint get penalized on a tiered basis; the idea being they haven’t been as upfront on this issue. That means a company that has reported its emissions two or three times in the past five years will get penalized 10% on their score while a company that reported just once in five years gets docked with a 15% penalty.

“If a company reports nothing and we have to substitute in the industry-level estimate for it, we’ll consider them an average player in their industry and we penalize them 25%,” Waldrep said, adding they prefer to error on the side of caution with the fund’s portfolio holdings and strive to hold companies actively minimizing their carbon footprint.

The end result, according to TruShares, is that the ECOZ fund’s weighted average carbon intensity as of year-end 2020 was 27.56 versus 156.42 for the S&P 500.

The fund does pay attention to the social and governance principles as well, and its two-step investment process starts by screening companies against traditional aspects of ESG best practices ranging from their promotion of leadership diversity to implementing minority hiring practices, along with carbon emissions reductions.

“We emphasize different factors based on the sector they’re in because there is no simple one-stop shop for these issues,” Waldrep said. "We want to evaluate companies that are preparing for what’s to be expected of them from consumers, investors and governments in the future. That means we want companies that are preparing for the economy of tomorrow and are aware of the real risks for them going forward.”

That produces an investable universe of roughly 100 to 150 companies, and these are assigned an ESG rating. The second phase of the process involves additional analysis to ascertain a company’s intrinsic value and comparing that to its share price to determine its relative value. Those companies making the cut (the portfolio currently has about 70 positions) are ranked based on their ESG rating and relative value.

The fund’s recent top holdings included electric vehicle maker Tesla and solar energy company Enphase Energy. Other top holdings included stalwart tech names Microsoft, Alphabet, Amazon.com and Apple. Its expense ratio is 0.58%.

“ESG is becoming more important to investors and regulators and governments, so companies are improving," Waldrep said. “You can say it’s greenwashing, but the reality is companies like Google, Amazon, Facebook and Apple have been making big green initiatives because it makes sense for them to do it because they’re getting ready for the regulations of tomorrow.”

Active Or Passive
Other funds have also developed processes to help quantify how well companies are meeting ESG standards and making a positive societal impact.

The Humankind US Stock ETF (HKND), for example, takes a passive approach to quantifying ESG by tracking a self-created index incorporating public disclosures from individual companies and tapping into data sources from various third-party research houses, scientific and academic papers, government agencies and NGOs. Companies are ranked based on a quantitative analysis of their positive and negative contributions to society as measured by their impact on investors, consumers, employees and society. In total, this is described as a company’s “humankind” value.

The long list of factors considered when determining these scores range from greenhouse gas emissions and slave labor to plastic pollution and predatory lending.

Next, the index methodology applies a proprietary algorithm that adjusts each company’s humankind value on the basis of its supply chain relationships, which is gleaned from company-to-company links disclosed in company filings, as well as by analyzing industry classification frameworks that determine the supply chain links between industries.

The end result produces a score that is meant to represent a company’s true social and economic value to humanity. Companies within the index are weighted by their humankind value score.

This fund debuted in February and has an expense ratio of 0.11%.

When it comes to quantifying ESG, the two funds mentioned in this article represent the “active vs. passive” debate that permeates the ETF industry. So far, the TrueShares ESG Active Opportunities ETF has turned in impressive results but has only a little less than $9 million in assets after nearly 13 months of trading.

The Humankind US Stock ETF, which is just a month old, already has $28 million in assets. 

Then again, judging ESG funds by asset levels is a shallow measuring stick that matters more to fund sponsors than to investors, who are more concerned with share price performance and whether ESG funds are actually making a difference on environmental, social and governance issues.