Is large cap focus a problem for ESG trackers?

Added 14th November 2016

Passive ESG strategies tend to focus exclusively on large caps. This is a problem because they miss out on ESG opportunities in small cap companies that can only be exploited by active managers, according to Ryan Smith, head of ESG research at Kames Capital. Does he have a point?

Is large cap focus a problem for ESG trackers?

Smith contends many ESG trackers are skewed towards stocks that are most transparent when it comes to their sustainable practices. But purely measuring company disclosure does not always translate into a more ethical or sustainable business, he says. 

“Focusing predominantly on those companies that make good environmental, social, and governance (ESG) disclosures can result in a bias towards certain sectors, while overlooking the genuinely good opportunities,” says Smith.

Trackers outperform

These limitations have not stopped passive ESG strategies to consistently generate better returns after costs then actively managed ESG funds over the past 10 years though. Moreover, all MSCI’s ESG-screened equity indexes have outperformed over the long-term in most equity markets.

An important factor explanatory factor as far as the failure of actively managed funds to exploit their perceived advantage of a ‘wider opportunity set’ is their elevated cost. According to Morningstar, active ESG funds have an average total expense ratio of 1.97%. That’s four to five times the charge of an ESG-screened ETF.

However, this does not mean that Smith doesn’t have a point at all. While ETF providers such as Blackrock and UBS have launched a flurry of ESG-screened ETFs in recent years, these are all focused on the large cap universe. Investors seeking exposure to sustainable small caps have no choice but to buy an active fund, for now.

Active small cap fund managers tend to market their funds by emphasising small cap companies are often ‘underresearched’, and therefore offer more opportunities. It’s probably indeed harder to measure the sustainability of such less transparent companies.

And that may be the reason ESG-screened small cap ETFs are yet to be launched, though some ETFs will be coming to the market soon, according to sources at index provider MSCI. But it’s by no means a given these products will be as successful performance-wise as their large cap counterparts. 

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Tjibbe Hoekstra

Senior Reporter

Tjibbe joined Expert Investor as a senior reporter in March 2014. Before moving to London he worked as a financial news reporter for various news outlets in Amsterdam, including Reuters and ANP, the main news agency in the Netherlands. He also worked for Fondsnieuws, a website and magazine for finance professionals in the Netherlands. Tjibbe holds a MSc in Public Administration and a post-graduate diploma in Journalism.

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