Passive Index Funds Pushed To Be More Active Voice For ESG

Until recently, socially responsible investing has been a backwater in the investing world. But investors — particularly activist groups — now demand more environmental, social and governance (ESG) responsibility from corporations.=

According to a survey by Brown Brothers Harriman and ETF.com, 51% of investors say ESG carries some level of importance, up 14 percentage points from last year. There are 169 ESG mutual funds and 56 ESG ETFs, according to Morningstar.

“It’s definitely being driven by investor feedback or the appearance that you want to be ahead of the game on this,” said Scott Sacknoff, chief executive of SerenityShares, which manages the ESG-focused SerenityShares Impact ETF (ICAN). ICAN, which launched in April, has $4 million in assets and an expense ratio of 0.5%.

ESG’s increasing popularity has raised questions about whether stock and bond index fund managers could and should be doing more to use proxy votes to steer companies in the indexes toward higher ESG standards.

Morningstar recently published a paper examining the issue, “Passive Fund Providers Take an Active Approach to Investment Stewardship.”

The paper found that while European managers have been active for years through the two stewardship tools of engagement with corporate management and proxy voting, index managers in the U.S. and Japan have only recently begun this process.

Of the five U.S. fund managers surveyed, BlackRock, Vanguard, State Street Global Advisors, and Fidelity Investments said they were increasing their engagement efforts, despite the costs. Only Charles Schwab (SCHW) said it would not.

“While we don’t meet with individual companies, we do engage with issuers in a systematic way through our proxy voting,” a Schwab spokeswoman told IBD. “We have yet to see evidence that with a portfolio as large as ours (by number of companies), direct engagement would provide measurable improvements for shareholders.”

The Morningstar paper addresses the main issue: “It may be tempting to assume that (since) index managers are passive owners (they) have little incentive to devote resources to monitoring companies; after all, they tend to compete on fees and their primary objective is to match the performance of indexes.”

Another issue is that since index managers have no choice in the stocks they hold, why should they care what the companies do?

“That’s why we say they have a duty to influence these companies to promote better ESG policies,” said Hortense Bioy, Morningstar’s director of passive fund research in Europe and the report’s co-author. “Because they are stuck with these companies. They are long-term investors, and they own everyone in the market. So they have a unique responsibility to change these companies for the better. That is the whole argument. As opposed to active managers, who if they disagree with the way a company is run, they could just divest it and not care, and only invest in the ones they believe will outperform the market.”

While for the most part, index managers vote with corporate management, sometimes their huge shareholdings can result in visible change. In 2016, a shareholder proposal asking ExxonMobil to be transparent and disclose its risk to climate change wasn’t backed by BlackRock. Instead, BlackRock held private discussions with the oil company’s management asking for the same thing as the activists. But it saw no results, so in 2017, when shareholders put forth the same proposal, BlackRock publicly voted for it, helping it pass.

“BlackRock believes that engagement is the best way to drive change on important environmental, social and governance issues,” said BlackRock spokesman Ed Sweeney, adding the firm has been doing this since 2011. “As a long-term investor, we are willing to be patient with companies when our engagement affirms they are working to address our concerns. However, our patience is not infinite — when we do not see progress despite ongoing engagement, or companies are insufficiently responsive, we will vote against management. We view a vote against management as a sign of a failed engagement, not as the start of the process.”

While large asset managers are favorite targets of activist groups, their pressure doesn’t always bear fruit. In November, an activist shareholder group proposed that Vanguard Group divest itself of PetroChina and Sinopec Shanghai, two Chinese energy firms doing business in Sudan. The group accused the companies of genocide. Vanguard recommended its shareholders vote against the proposal. The proposal failed.

But what about returns?

“ESG started not to improve the world, it was started by big banks to get a handle on risk,” said Janet Brown, president of FundX, a San Francisco RIA, and manager of the FundX Sustainable Impact Fund.

“Research shows higher ESG scores lead to more efficient, better earning companies,” Brown said.  “About 2,000 academic studies show a positive correlation between higher ESG and positive returns.” She was citing a study in the Journal of Sustainable Finance & Investment published in 2015.

It’s not just academic studies. A 2017 survey by State Street found that more than 68% of institutional investors reported that integrating ESG into their process had “significantly improved their returns.”

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Emerging Market ETFs See 5 Months Of Inflow

Emerging-market exchange traded funds have seen five straight months of inflow from investors, especially into Asian markets, reversing last year’s trend, while European equity funds have seen outflow.

With the U.S. equity markets hitting all-time highs, market analysts consider Asian markets cheap in a world with few bargains. They are encouraged by recent stabilization of the Chinese economy, improving fundamentals throughout Asia, and optimism over the recent elections in India and Indonesia.

In addition, the Federal Reserve’s tapering of its quantitative easing strategy has not resulted in higher Treasury yields, which many fear would mean more expensive borrowing costs for emerging-market countries.

“There is also a lot of excitement over the Shanghai-Hong Kong Stock Connect,” said Richard Peterson, who is the managing director of MarketPsych.com, a behavioral finance consultancy based in New York.

The program is expected to start in October. Global investors will for the first time be able to trade the Shanghai A shares, which are now available only to Chinese investors via the Hong Kong stock exchange. Chinese investors will also be allowed to trade the previously unavailable Hong Kong H shares.

In August, emerging-market equity ETFs, including China funds, received inflow of $4.7 billion, according to BlackRock ETP Research. Inflow was down from the $6.3 billion posted in July, on expectations of rising U.S. interest rates, which could pull investment money out of Asian and back to the U.S. Still, over the past five months emerging-market ETFs have gathered $17.6 billion.

Vanguard Attracts Flow

Vanguard FTSE Emerging Markets ETF (ARCA:VWO), the largest emerging-market ETF tracked by research house XTF, recorded $1.7 billion in inflow over the last three months. The $49 billion VWO is up 8% this year. It has an expense ratio of 0.15% and a yield of 2.47%. The fund has 43% of its assets in emerging Asia and 21% in Latin America.

Subtracting the outflow of the first three months of the year, emerging-market equity’s net inflow of $11.6 billion as of August has surpassed the $10.4 billion of redemptions posted in 2013, said BlackRock. Last year’s net outflow came on the heels of a Chinese banking crisis, an overheated property market, fear of a hard economic landing in China, and regional currency weakness based in anticipation of rising U.S. interest rates.

IShares MSCI Emerging Market ETF (ARCA:EEM), the second largest emerging-market ETF, with $41.9 billion in assets, had net inflow of $2.01 billion the past three months, according to XTF. The fund is up 5% this year. It has an expense ratio of 0.67%.

BLDRS Emerging Markets 50 ADR (NASDAQ:ADRE) is the second best performing ETF in the emerging-market category, up 13% year to date. The fund tracks the performance of about 50 emerging-market American depositary receipts. This ETF charges an expense ratio of 0.3% and had a yield of 3.5%.

“We are seeing in Europe grave concerns about the economic rebound and a lot of political uncertainty in Latin America,” said Andrew Karolyi, faculty director of the Emerging Markets Institute at Cornell University’s Johnson Graduate School of Management. “People withdrawing capital from Europe need to deploy it somewhere, and Asia looks like the least bad option.”

For full article see Investor’s Business Daily.

Fidelity Takes on State Street

Reading List for Monday, Jan. 7:

Fidelity’s new push into ETFs means it’s getting into the ring with cross-town rival State Street Global Advisors. The Boston Herald says Fidelity “is getting less and less business from investment advisers because it used to be that an investment adviser would pick a basket of mutual funds and Fidelity would be 30 percent or 40 percent of them.”

Wall Street Sector Selector does some technical analysis on the SPDR S&P 500 (SPY) and concludes “U.S. stocks and ETFs now face a moment of truth after the recent powerful rally.  Technical resistance and fundamental headwinds persist along with ongoing political uncertainty. “

Ari Weinberg explains in WSJ.com how ETFs lend out their securities for some extra cash. International securities regulators are in a tizzy over how this could cause potential disruptions in the market. But ETFs in the U.S. are much more stable than the derivative-based ETFs in Europe, so it’s not much of a concern on this side of the pond.

ING Likes Value Stocks, Emerging Markets and Europe in 2013

Just like the Christmas season, forecast season rolls around this time of year with investment advisors predicting what the new year holds and where we should all be putting our investment dollars. Ahead of us looms the fiscal cliff, a combination of tax increases and large government spending cuts that could chop as much as 4% out of the gross domestic product. Should the fiscal cliff go into effect it could put the current tepid economic recovery into jeopardy.

In a press briefing at ING’s offices Tuesday, Paul Zemsky, ING Investment Management’s chief investment officer of multi-asset strategies, said he expects the fiscal cliff to be resolved by the end of this year, with a negative impact of just 1% to 1.5% to GDP. He expects to see an end to the payroll tax holiday and the Bush tax cuts for the highest-income brackets. He also expects capital gains taxes to rise to 20% and dividend taxes to revert back to taxpayers’ regular rate from 15% now. Should the Congress wait until after the new year, Zemsky expects to see a major sell off in the equity markets. “It could be as much as a 10% drop, but we would expect this to be a V-shape bounce because the government would have to fix the problem. We would consider this a buying opportunity should it happen.”

Stocks remain cheap relative to bonds, said Zemsky, and both U.S. and global equities are attractive investments right now with price-to-earnings ratios around 15. Zemsky said the housing market has bottomed and is poised to rise, however investors have not yet realized this. As housing prices bottom, this makes collateral stronger, said Zemsky, adding now is the time to increase investments in U.S. financial stocks.

Overall, ING expects 2013 will bring modest growth in the U.S., continued growth in emerging markets and the end of the European recession. Zemsky’s overall forecast predicts U.S. GDP to see 2% to 3% growth next year, which will lead to 5% to 7% earnings growth in the S&P 500. He expects the S&P 500 to grow 8% to 10% next year with a year-end target price between 1550 and 1600. U.S. value stocks and emerging market equities look especially attractive in 2013.

The most popular ETFs tracking these areas of the market are the SPDR S&P 500 (SPY), the Financial Select Sector SPDR (XLF) and the Vanguard MSCI Emerging Markets ETF (VWO). Click here for a list of ETFs that track U.S. value stocks.

Zemsky added that it might be time to begin overweighting European equities. He said people are too negative on Europe. While there is still risk in there, he said the Euro Zone is beginning to stabilize and this could lead to higher equity prices. Click here for a list of ETFs that track European stocks.

As for the bond market, Christine Hurtsellers, ING’s chief investment officer of fixed income and proprietary investments, said the U.S. market is not pricing in any changes in policy from the U.S. Federal Reserve Bank. She says it’s time to underweight U.S. Treasury bonds and high quality investment grade U.S. credit. She recommends moving into emerging market debt, especially high-grade sovereign debt. The PowerShares Emerging Markets Sovereign Debt Portfolio (PCY) covers this market.

U.S. Large-Caps’ Net Cash Inflows Top Bonds

Net cash inflows in U.S.-listed ETFs surged to $55.8 billion in the third quarter, far exceeding the average quarterly inflows of $33.8 billion seen over the last three years, according to the ETF research team at Morgan Stanley Smith Barney. With $133.4 billion for the first three quarters of the year, ETF net cash inflows are “on pace for the biggest year on record,” says Morgan Stanley. This would beat the $174.6 billion that poured into U.S.-listed ETFs in 2008.

Investors made a big switch to risk as ETFs following U.S. large-cap indices received $11.0 billion, the largest net cash inflows for the quarter, compared with $8.1 billion for fixed income ETFs. This was a big change from the previous quarter when fixed income ETFs received about $19 billion. ETFs tracking high-yield corporate bonds topped the fixed-income segment with inflows of $4.4 billion, according to Morgan Stanley.

With 20 new ETFs launched in the third quarter, and another 11 in October, the number of ETFs stands at the extremely cool total of 1,234. Total assets in the U.S. ETF market, as of Oct. 25, were $1.3 trillion, a 21% increase since the beginning of the year.

The top three funds in terms of net cash inflows were the SPDR S&P 500 ETF (SPY), with net inflows of $7.4 billion, the SPDR Gold Trust (GLD), with $4.1 billion, and the Vanguard MSCI Emerging Markets ETF (VWO), with $3.9 billion, according to Morgan Stanley. Currency ETFs experienced the largest net cash outflows for the quarter, at $71 million. For the first nine months of the year, currency ETFs have seen outflows of $2.0 million. Most of the outflows came from ETFs bullish on the U.S. dollar, while most of the inflows went into funds bullish on the euro vs. the dollar.

Blackrock continues to be the market leader with 280 U.S.-listed ETFs and $528.4 billion in assets. This accounts for a 41.7% share of the market, says Morgan Stanley, down from 48% at the end of 2008. State Street Global Advisors, with $235.8 billion in 116 ETFs holds 18.6% of the market, down from 27% at the end of 2008. Vanguard had $231.6 billion in 65 ETFs, giving it a market share of 18.3%, up from 8% at the end of 2008. Through the first three quarters of the year, Vanguard has had net cash inflows of $41.2 billion, the most of any provider, says Morgan.

iShares Losing Market Share to Low Cost Providers

Reading List:

iShares losing market share to cheaper competitors. As of July 9, iShares held 40.7% of U.S. ETF assets, down from 43.2% two years ago. Meanwhile, Vanguard’s share grew to 17.7% from 15.9% two years ago.

Three income ETFs that can give you well-diversified exposure to some of the top dividend-paying stocks.

So many ETFs look alike. Here’s how to find a winner.

ETF Outflows Topped $2.5 Billion Last Week

ETFs posted net outflows of $2.5 billion last week, a period during which the S&P 500 fell 4.7%, says Morgan Stanley in its weekly ETF report. It was a huge amount considering the Thanksgiving holiday shortened the week to just 3 ½ trading day.

U.S. equities led the march out of the market with $3.1 billion in net outflows, with large-cap stock ETFs seeing the most redemptions, about $2.9 billion, according to the report. This has brought the total of U.S. ETF assets down 1% year to date to $991 billion, on a combination of lower asset values from market declines and net outflows.

Despite the flight from U.S. equities, the Vanguard Small-Cap ETF (VB) saw the most inflows of any ETF last week, $1.1 billion. In addition, Vanguard equity ETFs made up five of the top 10 ETFs to see net inflows last week. The other four were Vanguard Mid-Cap ETF (VO), Vanguard Small-Cap Growth (VBK), Vanguard Small-Cap Value (VBR) and the Vanguard Value ETF (VTV).

Meanwhile, the SPDR S&P 500 (SPY) saw the largest outflows for the 1-, 4- and 13-week periods. The SPDR lost $1.2 billion in assets last week. The iShares Russell 2000 Index Fund (IWM) saw the second-most outflows, $1.0 billion.

Over the past 13 weeks, fixed-income assets saw the greatest inflows, $15.8 billion vs. $32.5 billion for all asset classes. Fixed-income ETFS now make up 18% of all ETF assets, up from 14% at the beginning of the year, says the report.

The Russell Reconstitution And Your ETFs

The biggest event on the indexing calendar is the annual reconstitution of Russell Investments’ flagship Russell 3000E Index, of which the Russell 3000, Russell 2000, Russell 1000 and Russell MicroCap Index are subsets.

While changes to the Dow Jones Industrial Average and S&P 500 make big news, they’re few and far between, largely at the subjective discretion of the indexes’ custodians. You can’t plan for or truly predict the changes. Russell’s change can be seen from a mile away.

And it’s a big deal. With $3.9 trillion in managed assets benchmarked to its U.S. indexes, according to Russell (around $542 billion of that in indexed assets), the activity surrounding the annual reconstitution makes June 30—switchover day—one of the U.S. equity market’s largest trading days of the year. The rebalancing forces the movements of many stocks in and out of indexed portfolios as managers try to get the best price for their shareholders amid a huge amount of trading volume.

Negotiating The Transition

“We do a lot of work, months ahead of time, to anticipate the movement from the small-cap index to the large-cap index and vice versa,” said Greg Savage, managing director of iShares’ portfolio management.

According to BlackRock, iShares’ parent, at the end of March there was $83.9 billion in ETF assets following Russell indexes. And while iShares only sponsors 16 of the 70 ETFs tracking Russell’s U.S. indexes, it holds the lion’s shares of the money, with $74.4 billion in assets under management.

The biggest issue affecting passive funds replicating these indexes is the idea of a “free lunch” for traders and active funds that front-run the reconstitution.

You might assume that graduating from the small-cap Russell 2000 to the large-cap Russell 1000 is a good thing for a company. But from a flows perspective, it’s quite the opposite.

When a stock falls from the large-cap Russell 1000 Index to the small-cap Russell 2000, there can be buying pressure. As the smallest stocks in the large-cap index, they may be excluded from both optimized index and actively managed funds. However, when they move to the small-cap index, they tend to be the largest stocks in the new pool, granting them some of the largest weights in that index. Managers of the small-cap fund could potentially buy a lot more shares than the large-cap fund managers will sell.

Meanwhile, opposing high selling pressure occurs when a stock graduates from the Russell 2000 to the Russell 1000.

Consider Capitol Federal Financial (CFFN), a company with a market cap of $1.9 billion. It currently has a weight of 0.000036 percent in the Russell 1000, after falling more than 35 percent over the past 12 months. Given its low ranking, it will likely drop into the Russell 2000 during the rebalance. But what will be the impact?

Estimates say that $135 billion is benchmarked to Russell 1000-linked index trackers. Given CFFN’s weight, that means these funds own about $4.9 million of the stock. If and when it moves to the Russell 2000, it will become a bigger fish.

Based on current levels, it would represent about 0.15% of the index. With $44.2 billion tied to Russell 2000 trackers, those funds would have to buy $6.6 million of the stock. Much of that can slide over from Russell 1000 funds exiting the position, but given the current numbers, there would be a net $1.7 million purchase taking place at the close on the day of the rebalance. That’s the equivalent to 11% of the stock’s average daily volume—a significant, but not overwhelming buy order. However, mutliply that out over hundreds of stocks, and you get some major market-moving activity.

“Some fund managers want to offset the price movements that they think are part of the front- running,” said Joel Dickson, senior ETF strategist at Vanguard. The Valley Forge, Pa., fund company runs seven ETFs tracking Russell indexes. “However, passive managers don’t want to beat the index. They want to minimize the tracking error with respect to the underlying stocks. So, if the goal of the ETF is to provide exposure to the Russell index with low tracking error, then that is attained by doing all your trades on the day of the reconstitution. That way, the front-running doesn’t matter.”

For the full story to go IndexUniverse.com.

Might Still Be Too Early to Buy Europe ETF

And then there were three. The European debt crisis took a step backward Monday after Portugal received an $11 billion bailout from finace ministers of the European union. This is the third bailout over the past year by the European Union in the infamous PIGS country appellation. With Portugal, Ireland and Greece having succumbed to poor fiscal policies, the only PIG remaining is Spain, and its future remains in doubt.

With Portugal taken care of, Greece returns to the top spot among Europe’s biggest worries. Pimco’s bond king Bill Gross, who runs the world’s largest bond fund, says Greece is the world’s No. 1 candidate for default.

And that problem has gotten even worse with the weekend arrest of Dominique Strauss-Kahn, the head of the International Monetary Fund.

Last week, I spoke with Dimitre Genov, the senior portfolio manager of the Artio Global Equity mutual Fund, about his view on Europe, Japan and the global economy.

Genov says while Germany, France and the Netherlands are strong, most of the continent is still weak and it’s obvious that Europe’s financial problems have not been solved. The European Central Bank is buying time as it tries to take more proactive measures to fight the debt crisis. Genov says that Greece still can’t compete and that it’s wages are too high. He says it’s inevitable that that Greece will need to restructure its debt. He expects this to lead to more downside in European stocks.

However, Genov doesn’t think Spain will go into default. “It’s more a liquidity problem,” say Genov. “They are making moves to liberalize the labor market. They need to get rid of the wage rigidity to become more competitive and more efficient.”

Many of the European governments need to deal with debt, he says, but they’re finding it very difficult because none of the politicians are willing to make hard choices. “The market has to force them to do it,” says Genov. And while he says there are definite bargain stocks to be found in Europe, many will end up being value traps as the entire continent faces years of deleveraging. Meanwhile, he thinks Japan is facing structural decline as well, and sees a lot of deleveraging.

Overall, he recommends investing in emerging markets despite their poor performance lately. “We still like China,” says Genov. “ The economy may be slowing down but 7% to 8% a year is still significant growth.” He says the multiples in Chinese assets have compressed. He suggest consumer stocks as food prices have rolled over and inflation should peak in the next quarter or two.

Still, he says the market is entering a seasonally weak period and metrics have started softening, so it’s quite possible the current pullback in the stock market could post a significant decline. “The U.S. won’t enter a recession this year, but expect a slowdown before more upside.”

Vanguard’s MSCI Europe ETF (VGK) holds stocks from Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the United Kingdom. The expense ratio is just 0.14%.

5 Excellent ETFs for Emerging Markets

Emerging-markets stocks are short of breath, which is understandable. Over the previous two years, and for most of this millennium, the stock indexes in up-and-coming countries blew away the Dow Jones industrial average, the Nasdaq 100 index, Standard & Poor’s 500-stock index and other popular benchmarks in the developed world. But now it’s 2011, and emerging markets are backtracking. The benchmark MSCI Emerging Markets Index, which measures 21 emerging-markets country indexes, has lost 5.2% so far this year. The S&P 500, by contrast, is up 1.7% (all return figures are through March 17).

This might warn you to stay away from emerging markets, or if you’ve been investing profitably in these nations, to bring your money home. We disagree. Instead of cashing out, this is an excellent time to enter emerging markets or to increase your stake, and using exchange-traded funds is a great way to do so. The future remains bright for Asia, Eastern Europe and South America, a group of markets headed by the BRICs — Brazil, Russia, India and China — and also featuring such prosperous countries as South Africa, South Korea and Taiwan.

There’s no denying the present problems. A big reason for the emerging markets’ decline so far in 2011 is high inflation, fueled by record or near-record prices for oil and other basic materials, plus soaring food costs. To keep inflation from getting out of control, central banks in some developing countries have raised interest rates and may push them higher. Rising rates slow economic growth by increasing the cost of borrowing. At least one analyst fears that the emerging nations may not raise rates enough to tame rising prices. “We think the primary driver [for the stocks’ decline] is a lack of emerging-market central-bank inflation-fighting credibility in the face of mounting food-driven pricing pressure,” says Alec Young, Standard & Poor’s international stock strategist.

Turmoil in the Middle East and North Africa and the devastating earthquake, tsunami and nuclear-power-plant crisis aren’t helping matters. Though most African and Middle Eastern countries are classified as frontier markets, which are less liquid and more lightly regulated than emerging markets, some investors worry that non-democratic countries that do have the status of emerging markets may also suffer disruptions. And the disaster in Japan has the potential of slowing growth all over the world because of disruptions in the global supply chain.

Nevertheless, the reason to invest in this group still holds: Most of the world’s growth for the next ten years will come from emerging economies. With a few exceptions, they are not drowning in debt, and they didn’t suffer badly from the credit meltdown. They have young, growing middle classes that are buying cars and houses and like to spend their newly earned discretionary income as they please. If all pans out, says Michael Gavin, Barclays Capital’s head of emerging-markets strategy, developing-markets stocks will return an annualized 10.5% through 2021. Those kinds of returns are worth shooting for.

A Broad Index ETF

To earn the return of the MSCI Emerging Markets Index, buy Vanguard MSCI Emerging Market Stock ETF (VWO). You start with the advantage of the lowest expense ratio in the emerging-markets sector, 0.22%, plus you get a dividend yield of 1.8%. The top countries by weighting are China, 17.6%; Brazil, 16.3%; South Korea, 13.7%; Taiwan, 11.2%; South Africa, the only African country in the index, 7.5%; Russia, 7.4%; and India, 7.2%. The fund is down 5.2% this year, but has returned an annualized 43.8% over the last two years, and 12.7% annualized since its creation in 2005.

This ETF doesn’t carry the risks that a manager may pick the wrong stocks or the wrong countries. The drawback is that because it invests only in large and mega-size companies, many of which do big business in the U.S. and Europe, you aren’t making a pure and direct investment in the growth of emerging nations. But so far that hasn’t been much of a drag on results.

To read about the other four ETFs:

• WisdomTree Emerging Markets Equity Income Fund (DEM)
• WisdomTree Emerging Markets SmallCap Dividend Fund (DGS)
• SPDR S&P Emerging Asia Pacific ETF (GMF)
• iShares S&P Latin America 40 Index Fund (ILF)

Go to Kiplinger.com.