WisdomTree’s Approach to Broad-Based ESG Investing

ESG investing has been a focus for European institutional investors for more than a decade. Now it’s increasingly become an area of conversation for U.S. investors as asset managers expand their product lineup to incorporate “environmental, social and governance” considerations. 

Seeing the increase in investor interest for these types of products, WisdomTree began developing its own approach to broad-based ESG investing. As with other asset classes, WisdomTree aims to create a methodology that gives investors exposure to the relevant investment theme while avoiding common pitfalls. 

This is not WisdomTree’s first foray into the ESG space—since 2014, WisdomTree has offered “governance”-focused Indexes as part of its ex-state-owned enterprises family. These provide investors with broad exposure in the emerging market region while removing the inherent governance risk of state-owned enterprises. In January, we added additional screens to this Index family to enhance its environmental and social considerations. We highlighted these additional ESG enhancements in a post earlier this year.  

WisdomTree’s Broad-Based ESG Approach

After years of research, WisdomTree restructured three funds in March 2020 to target ESG from a factor-based investing lens. Combined, these Funds would provide investors with a global ESG exposure (and can complement our EM-specific ex-state-owned ESG family):

• WisdomTree U.S. ESG Fund (RESP)

• WisdomTree International ESG Fund (RESD)

• WisdomTree Emerging Markets ESG Fund (RESE)

WisdomTree’s multifactor approach to ESG investing includes both a negative screening of companies on sustainability characteristics—such as product involvement and noncompliance with the UN Global Compact—and a positive integration of a sustainability score to determine holdings and their respective weights. The final basket aims to give investors a low-tracking-error portfolio (relative to the broad benchmark) with strong ESG characteristics constraining any significant country or sector differences.

This approach was designed to address some of the most common pitfalls found in other ESG methodologies, with the goal of balancing an investor’s sustainability objective with superior risk-adjusted returns. WisdomTree uses Owl Shares, a data provider that aggregates ESG scores from a variety of sources, and adjusts these scores to reflect what its model classifies as the most important indicators. Some of these main pitfalls include unintended size (larger companies tend to report more ESG data) and sector and country biases that contribute to active risk and can cause a drag in relative performance in certain market environments.

Investment Process

The investment process for these Funds starts with a broad-based regional universe—U.S., international or emerging markets—and screens out companies that derive revenue from activities related to fossil fuels, controversial weapons or tobacco, or those which do not comply with the United Nations Global Compact Principles, which are focused on human rights, labor, environment and anti-corruption efforts. We then assign a score to each eligible company based on a composite calculation that combines traditional investment factors like value, quality, momentum and low correlation with a sustainability factor made up of environmental, social and governance considerations. 

The 300 stocks with the highest composite scores are selected to be in the portfolio, and their weight is determined by combining their market cap and sustainability score in equal proportions. Thus, the sustainability factor plays an important role in both the selection and weighting of companies in the portfolio. 

A final adjustment is made to each company’s weight to ensure that both the portfolio’s sector and country exposures remain within +/-5% of their respective weights in the broad-based starting universe. This investment process is repeated quarterly, resetting portfolios to the desired exposure.

Portfolio Construction Example

The chart below exemplifies the investment process and the potential advantages of having an ESG approach that both screens out companies with certain sustainability characteristics and integrates a sustainability factor into the stock selection and weighting. 

The starting universe of 800 stocks had roughly 20% of its weight in companies that ranked in the bottom 60% of ESG scores, which is in line with its benchmark, the S&P 500 Index. After screening close to 150 companies based on their sustainability characteristics, the sector composition changes slightly: financial quality (return on equity) improves, but valuation metric price-to-earnings (P/E) and, more importantly, ESG scores stay the same. Finally, selecting the 300 companies with the highest composite scores and implementing the weighting schema results in improved financial metrics (P/E, ROE) and ESG characteristics, versus both its starting universe and the S&P 500.

For definitions of terms in the chart, please visit the glossary.