FlexShares Blog

Understanding Volatility and the FlexShares ESG Process

Posted by David Partain on Sep 4, 2017 8:30:00 AM

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For some investors, considering environmental, social or governance (ESG) factors as part of the investment process may be based upon more than a desire to “do good." Investors will sometimes use key performance indicators (KPIs), which are quantitative and qualitative metrics reported by public companies as part of their regulatory filings, which demonstrate how effectively a company is achieving its business objectives, which often include ESG considerations. ESG in our opinion is as much about managing risk and boosting investment returns as it is about any altruistic motivations.

We offer two ESG-focused funds here at FlexShares:

  • FlexShares STOXX® U.S. ESG Impact Index Fund (ESG)
  • FlexShares STOXX® Global ESG Impact Index Fund (ESGG)

Our ESG investment process at FlexShares was designed to potentially provide investors with funds offering competitive risk-adjusted returns with the intention of helping them achieve their long-term investment goals. Research has shown that selected ESG KPIs are critical in determining a company's potential risk and future returns. [1] We look at these critical KPIs in our ESG process as a means to potentially manage the volatility and have a positive impact on the risk-adjusted returns of our funds.

Equal Focus

Environmental concerns seem to get much of the press when it comes to ESG, and many fund and investment managers focus on this aspect as well. We feel that integrating not only the environmental aspect, but also social and governance considerations, into our ESG process helps us choose companies that are at lower risk due to poor management of all aspects of ESG in their operations. We believe that companies with lower risks of financial consequences relating to poor management of these KPIs may experience less price volatility than companies who are at greater risk here.

Our Process

We've partnered with index provider STOXX to develop the indexes we use as benchmarks for ESG and ESGG. We engaged STOXX to analyze ESG KPIs to see if there were specific KPIs that could be identified as leading to long-term value creation for shareholders. Their research revealed indicators in each of the environmental, social, and governance areas that are most influential in contributing to potential risk and return. These findings are the basis for the STOXX benchmark indexes we use for ESG and ESGG. [2]

Beyond ESG KPIs, we utilize diversification controls in these two funds to ensure that the ESG screening is fully integrated with our investment principles to potentially limit risks for our investors. Specifically, we believe that the portfolio is well -diversified and that it is not overly skewed towards any particular stocks, sectors, or countries. Our diversification controls are designed to offer a fund that is:

  • Sector-/style- neutral
  • Allocation is not greater than +/- 5% of the benchmark index
  • Country allocation is not greater than +/- 1% of the benchmark index
  • Tracking error is greater than 3% versus both the S&P 500 and the Russell 1000 for the ESG fund, and greater than 2% versus the MSCI World Index for ESGG

We integrate ESG KPIs into our core investment process to produce fund portfolios that are designed to mitigate long-term investment volatility and provide greater potential for competitive, long-term risk-adjusted returns for investors. [3]

Written in conjunction with Roger Wohlner utilizing Contently. Roger is an experienced financial writer whose work has appeared on Investopedia, US News, Morningstar Magazine and MSN Money.


References

[1] Organization for Economic Co-operation and Development, "Investment governance and the integration of environmental, social and governance factors," 2017, https://www.oecd.org/finance/Investment-Governance-Integration-ESG-Factors.pdf

[2] Northern Trust, “ESG/ESGG Integration Process,” http://static.3playmedia.com/p/projects/13959/files/1364510/output_formats/46.pdf

[3] FlexShares.com, Why ESG May Finally Gain Traction,” https://advisors.flexshares.com/insights/insights-detail?c=bc2680b96dd5efd06491ef7e81e6db4a

FlexShares STOXX® US ESG Impact Index Fund (ESG) and the FlexShares STOXX® Global ESG Impact Index Fund (ESGG) are passively managed and use a representative sampling strategy to track their underlying index respectively. Use of a representative sampling strategy creates tracking risk where the Fund's performance could vary substantially from the performance of the underlying index. The Funds are subject to environmental, social and governance (ESG) Investment Risk, which is the risk that because the methodology of the Underlying Indices selects and assigns weights to securities of issuers for non-financial reasons, the Funds may underperform the broader equity market or other funds that do not utilize ESG criteria when selecting investments. The Funds are also at increased risk of industry concentration, where it may be more than 25% invested in the assets of a single industry. For ESGG, investments in foreign market securities involve certain risks such as currency volatility, political and social instability and reduced market liquidity. The Funds may also invest in derivative instruments. Changes in the value of the derivative may not correlate with the underlying asset, rate or index and the Funds could lose more than the principal amount invested.

The STOXX® USA ESG Impact Index and the STOXX® Global ESG Impact Index are the intellectual property (including registered trademarks) of STOXX® Limited, Zurich, Switzerland and/or its licensors ("Licensors"), which is used under license. The securities based on the Index are in no way sponsored, endorsed, sold or promoted by STOXX® and its Licensors and neither of the Licensors shall have any liability with respect thereto.

Topics: ETF


Before investing, carefully consider the FlexShares investment objectives, risks, charges and expenses. This and other information is in the prospectus, a copy of which may be obtained by visiting www.flexshares.com. Read the prospectus carefully before you invest. Foreside Fund Services, LLC, distributor.

An investment in FlexShares is subject to numerous risks, including possible loss of principal. Fund returns may not match the return of the respective indexes. The Funds are subject to the following principal risks: asset class; commodity; concentration; counterparty; currency; derivatives; dividend; emerging markets; equity securities; fluctuation of yield; foreign securities; geographic; income; industry concentration; inflation-protected securities; interest rate / maturity risk; issuer; management; market; market trading; mid cap stock; natural resources; new funds; non-diversification; passive investment; privatization; small cap stock; tracking error; value investing; and volatility risk. A full description of risks is in the prospectus. 
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