NULG: A Case Where ESG Investing Is Working

Introduction

One of the most debated topics concerning investing recently is whether Environmental, Social, and Governance, known as ESG, is a good investment strategy to follow. Even if results say yes, one could ask legitimately whether that is due to the ESG screening or just the massive inflows into ESG funds. This article will not debate these important questions but will compare the Nuveen ESG Large-Cap Growth ETF (BATS:NULG) to the SPDR Portfolio S&P 500 Growth ETF (SPYG). This will allow readers to see how the ESG screens alter the portfolio between two ETFs that otherwise focus on the same universe of Large-Cap stocks.

Based on results since NULG started in late 2016, it’s consistent outperformance over SPYG warrants a Buy rating for investors looking for Large-Cap US equity exposure. See an important disclaimers/caveat at the very end of this article.

Defining ESG investing

I thought about labeling this section “Trying to define ESG investing” as like many definitions in the investing world, there is not one universally accepted definition to that term or which funds should use it. Here is one definition of each term.

In the same article, Hank Smith, Head of Investment Strategy at The Haverford Trust Company provided his view why use ESG criteria and these included the following:

• "At its core, ESG investing is about influencing positive changes in society by being a better investor."
• "By considering ESG factors, investors get a more holistic view of the companies they back, which can help mitigate risk and identify opportunities."
• "ESG investing assumes that environmental, social and corporate governance factors impact a company’s overall performance."

I bolded the key word in the last statement as it is where all the debate centers around. Does a company with a good ESG score actually outperform competitors with lower scores? With each company potentially defining ESG differently and maybe focusing on different parts, another complaint/concern is there is no recognized ESG evaluation definition or standard, making comparisons and analysis suspect.

The US Securities and Exchange Commission has decided to help investors out when they adopted a new rule. The “names rule” changes mean that a fund’s name must match 80% of the fund’s portfolio. This not only includes names with ESG, but certain other characteristics like growth or value.

I tried finding a chart that shows the growth of AUM in ESG funds but only came away with no one knows due to the lack of a clear definitions.

Nuveen ESG Large-Cap Growth ETF review

Seeking Alpha describes this ETF as:

"The Nuveen ESG Large-Cap Growth ETF was launched and is managed by Nuveen Fund Advisors, LLC and is co-managed by Teachers Advisors, LLC. It invests in growth stocks of large-cap companies. The fund invests in stocks of companies that are deemed socially conscious in their business dealings and directly promote environmental responsibility. It seeks to track the performance of the TIAA ESG USA Large-Cap Growth Index. The ETF started in late 2016."

Source: seekingalpha.com NULG

NULG has $1.05B in Net Assets and has a 26bps expense ratio. The yield varies too much for me wanting to quote a number. More on that when the distributions are reviewed later.

Index review

This is how the index provider describes their product:

"The TIAA ESG USA Large-Cap Growth Index is based on the MSCI USA Growth index, its parent index, which captures large-cap securities exhibiting overall growth style characteristics in the US. The TIAA ESG USA Large-Cap Growth Index is designed to represent the performance of a TIAA strategy that aims to increase the Index’s exposure to positive environmental, social and governance factors as well as exhibit lower carbon exposure than the Parent Index. The index also aims to minimize the tracking error relative to the Parent Index through an optimization process."

Source: msci.com index

The index holds 112 stocks, compared to over 230 the non-ESG version of the index. The index is rebalanced quarterly. Inclusion/exclusion rules are provided in detail in the TIAA ESG Indices Methodology document.

NULG holdings review

The ETF currently holds 95 stocks, with a sector allocation of the following.

The Top 4 sectors are 81% of the portfolio weight. Three sectors are missing (Real Estate, Utilities, Health Care). At almost 40%, investors need a positive view of that sector and that of the US economy. Later, I will compare these to SPYG's sector allocations.

Multiple factors appeared to be used for setting a securities weight within its sector and then the Index, thus the ETF. The Top 20 holdings represent about 55% of the total weight.

The smallest 25 positions account for only 5% of the portfolio, limiting their ability to affect the ETFs performance.

NULG distributions review

Since inception, the ETF has only made distributions at year-end, including when special payments were made. As the table shows, income is only a small part of each annual distribution; STCGs and LTCGs account for a vast majority and explain the next chart that shows why a yield quote for NULG lacks value.

SPDR Portfolio S&P 500 Growth ETF overview

Seeking Alpha describes this ETF as:

"The SPDR Portfolio S&P 500 Growth ETF was launched by State Street Global Advisors, Inc and is managed by SSGA Funds Management, Inc. It invests in growth stocks of large-cap companies. It seeks to track the performance of the S&P 500 Growth Index. The ETF started in late 2000."

Source: seekingalpha.com SPYG

SPYG has $18.5b in AUM and has a lower fee of only 4bps. It sports a TTM Yield of 1.16%.

SPYG sectors/holdings review

Since sectors and holdings are what would be effected by adding an ESG screen, I briefly cover both for this ETF. Sharp eyes will notice that SPYG found growth stocks in all 11 sectors; the ESG rules did not. SSGA did not list which stocks were in each sector so I could not provide a count here.

Having all possible sectors in the portfolio helps to explain why the top four sectors here are only 70% of the total portfolio, less than what NULG has.

Comparing ETFs

In this section, sectors and holdings are compared to see the ESG effects.

There are only 48 stocks in both ETFs, with only 27% of the portfolio allocation weights overlapping. We can see that adding an ESG screen added allocations to Technology, Industrials, and Financials, while removing allocations for Energy and Health Care, the last one being completely missing from NULG. Looking at common positions, we see these as the biggest differences in weight. Remember, sector allocations more than likely will drive the ETF’s results.

I imagine Apple (AAPL) had its exposure reduced because of its supply chain dependence on China. The shifts in technology stocks touched many others too. As stated above, without insight into the ESG "black box" used, how a stock's weight is effected is only guessed at. On the flip side, NULG’s biggest overweight compared to SPYG is another mega Tech stock, Microsoft (MSFT).

When analyzing if ESG rules effected the allocation to Growth stocks, we see, according to Vanguard, yes it did with their classifying 72% of NULG to be Growth stocks versus only 42% for SPYG.

The above show what each ETF looks like today. Let's now look at how investors did with each ETF since NULG started in late 2016.

Looking at CAGR and risk data from PortfolioVisualizer, we see the following.

While the StdDev is higher for NULG, both the Sharpe and Sortino ratios indicate investors were rewarded for it. Except for the last three months, the all the other shorter time periods provided show NULG outperforming SPYG.

Risk analysis and portfolio strategy

A problem with contributing a set of results to one factor like an ESG screen, is understanding cause and effect. We can say with certainty that the ESG screen changed the composition of the portfolio compared to SPYG in terms of stocks held and the weight of each. But it also changed the sector allocation weights and we all know sectors do not move with a 100% correlation factor. If one had the daily return data for each stock of both ETFs, attribution analysis would tell us where the outperformance came from: stock selection, stock and/or sectors weights. I am sure some Finance PhD thesis in a drawer somewhere has that answer. If ESG puts the ETF in better sectors, for whatever reason, than it is the major factor as I see it.

With the above in mind, the question becomes what risks are inherited by ESG-filtered NULG versus owning an unfiltered ETF like SPYG. Here are a few that come to mind:

• With all the money that has flowed into ESG funds, has the Alpha available for new strategies already been captured? In short, history might not continue.
• Other strategies that have worked in the past turned out to be just a passing fade. Some believe that could be the case here as pushback against using ESG seems to be gaining steam. If so, despite predictions, the ETFs will lose their momentum/edge as inflows slow or become outflows.
• With no agreed upon definition of what ESG means, nor how Nuveen applies it, this unknown adds uncertainty risk to the ETF in that the screening rules could change without investors knowing it had.
• In more tangible terms, 5 of the 11 sectors have their weight shifted by 2+% when compared to the SPYG ETF, which, as mentioned, has the same market-cap growth focus without the ESG restrictions. While that is where the potential Alpha lies, it is also where some added risk comes from.
• NULG is very concentrated, having 25% of the portfolio in only four stocks. While that can work out well, it does adds a risk factor that a well-diversified ETF would not have.

The better "mousetrap" theory

From a young age, I have heard the yarn, "Build a better mousetrap and the world will beat a path to your door". To earn Alpha, you cannot own the market; one must invest in the parts they think will outperform, the better mousetrap. While the concept of ESG goes beyond investing, there are supporters who believe Alpha is possible by focusing on companies that have strong ESG policies and operate accordingly. That said, some ESG investing supporters defend the concept by saying the world benefits and investing returns are not harmed. I will leave that debate for others, but will acknowledge using ESG screening has worked for the NULG ETF. As they say, “Show me the money!”.

Conclusion and forward thinking

To give the NULG a Buy rating as I have done requires acknowledging to gain Alpha one, by definition of investing risk/reward, must take on more risk. That trade-off is what every investors tackles (or should at least address) every time to decide to buy or not buy an ETF. Also in support of my rating is that over both the past 10 and 20 years periods, Large-Cap Growth stocks have been the best performing market segment.

Since there is a positive result from the strategy difference between these two ETFs, and against the full S&P 500 Index as represented by the SPDR S&P 500 ETF (SPY), NULG has earned a Buy rating for Large-Cap Growth investors, but understand the risks as outlined above.

For others to agree with the Buy rating, they would need to agree with my forward thinking on the following points, such as:

• ESG screening will continue to work when applied against Growth stocks.
• Growth stocks will continue to outperform Value and Blend oriented funds within the same market-cap.
• Large-Cap stocks will continue to be favored over Mid-Cap and Small-Cap stocks. Who controls investment funds favors those stocks.
• Technology innovations drives many other industries. I do not see that ending and that favors the companies providing those improvements.

Final thoughts

While collecting data for this article, I saw that Nuveen has two other Large-Cap ESG ETFs, those being:

This led to my asking myself if these other ETFs showed the same positive results compared to their S&P 500 Index equivalent. This is what I found.

From early 2017, Value ESG investing was the worst performer.

From mid-2019, overall ESG investing lagged as measured by the SPY ETF.

Which leads to a very interesting question to explore with other funds: "Does ESG screen only work well, or best, when focusing on Growth stocks?". A quick look at Mid-Cap stocks where Nuveen also has a set of ESG ETFs, adds evidence that could be correct assumption.

Alex Pettee is President and Director of Research and ETFs at Hoya Capital. Hoya manages institutional and individual portfolios of publicly traded real estate securities. Alex leads the investing group known as the Hoya Capital Income Builder, which uses the investment knowledge of several Seeking Alpha analysts provide members with insightful articles covering mostly individual stocks or funds. Occasionally an article cover will cover an investing strategy or other topic that investors need to be aware of, such as law changes that might affect their long-term strategy.