Investors are increasingly weighing the importance of incorporating environmental, social, and governance (ESG) considerations into their investment guidelines. Yet many investors are concerned they could face a trade-off between social responsibility and investment performance in ESG-oriented investments.

To help address this dilemma, PIMCO has partnered with smart beta pioneer Research Affiliates to launch PIMCO RAFI ESG U.S. ETF. This ETF seeks to provide a total return that closely corresponds, before fees and expenses, to the total return of the RAFI ESG US Index. The Index is a long-only, smart beta index that seeks to achieve the dual objectives of social responsibility and long-term outperformance of the broad market by integrating ESG metrics with a time-tested smart beta strategy. Incorporating the latest research from Research Affiliates, RAFI ESG US Index offers an innovative solution that goes beyond typical ESG approaches.

In this Q&A, Rob Arnott, founder and chairman of Research Affiliates, Katy Sherrerd, CEO of Research Affiliates, and Laura Graff, equity product strategist for PIMCO, discuss the rationale for launching the RAFI ESG US Index and PIMCO RAFI ESG U.S. ETF and what sets it apart in the rapidly growing ESG investment space.

Q: Why did Research Affiliates create the RAFI ESG indices?

Sherrerd: We launched the RAFI ESG Index series to help guide investors pursuing the dual objectives of social responsibility and long-term outperformance of the broad market.

The ESG space has experienced tremendous growth over the past half-decade. According to the Global Sustainable Investment Alliance (GSIA)’s most recent review, more than $30 trillion of assets globally were being professionally managed under ESG strategies at the start of 2018. That represents growth of more than 30% since 2016.

This trend is likely to continue. Due in part to demographic shifts globally, we are seeing more people aligning their investments with their values, and they are making substantial efforts to reshape corporate behavior and to have their voices heard through various forms of activism. As a result, public pension sponsors and other asset owners are facing a surge of mandates to use their investing heft to achieve social goals such as reducing their carbon footprint and improving gender diversity, among others.

The growing popularity of ESG investing comes despite widespread views that it might involve a performance penalty. Although we at Research Affiliates believe the available research on the investment merits of ESG investing is mixed, we firmly believe that investors do not need to abandon investment performance to achieve their ESG objectives. The launch of PIMCO RAFI ESG U.S. ETF (ticker: RAFE) is part of our commitment to help investors interested in the dual objectives of social responsibility and the pursuit of long-term outperformance of the broad market.

Q: How does RAFI ESG US Index supplement standard ESG metrics to seek enhanced return potential?

Arnott: The RAFI ESG US Index incorporates 38 metrics across environmental (E), social (S), and governance (G) criteria into portfolio construction. Our index also goes a step further, incorporating metrics representative of financial discipline (FD) and diversity (D). Both our own research and research by others has led us to conclude that the financial discipline and diversity firms employ, which are both closely related to ESG principles, may be additive to both business performance and equity returns.

Financial discipline is one of the bedrocks of corporate governance. The extensive availability of corporate financial data has facilitated research into the connection between firm management, corporate outcomes, and investment results. To state the obvious, poorly governed companies that prioritize short-term gains for the benefit of management over the long-term benefit of shareholders fail to align with the good-governance intentions of ESG criteria, and instead chip away at shareholder value.

Academic research has identified four ESG-related metrics that indicate financial discipline and are associated with better investment performance: high profitability, low investment, low net issuance, and low accruals. These metrics have been incorporated into multiple Research Affiliates product suites since 2005 and are included in the RAFI ESG US Index to seek enhanced return potential over the broad market.

Sherrerd: At Research Affiliates, workforce diversity has long been an important topic both in our research and in the management of our own business. In addition to the growing recognition of the social benefits of diversity, research shows that diversity has a positive impact on business outcomes¹ – in particular, improved financial strength, higher net margins, higher compound annual growth rates, and higher valuations, along with more frequent product innovation and fewer instances of governance-related controversies.

The business case for diversity is grounded in research showing that teams whose members represent a mix of gender, ethnicity, experience, age, and culture and that actively cultivate inclusiveness tend to make better decisions and achieve a higher level of collective intelligence. While it is not possible (yet) to directly measure the collective intelligence of a firm, we believe the existing body of research provides substantial support for our conclusion that firms scoring well on measures of diversity, starting with gender diversity, are likely best positioned to produce the strongest long-run financial results.

The RAFI ESG indices incorporate measures that determine a firm’s commitment to gender diversity in particular – paying close attention to women in management, in the C-suite, and on company boards – in pursuit of higher investment returns.

Q: How does RAFI ESG US Index benefit from integrating ESG metrics with smart beta?

Arnott: In addition to enhancing traditional ESG metrics with return drivers linked to corporate governance, RAFI ESG US Index breaks the link between stock price and portfolio weight to generate an additional source of potential outperformance in the form of a rebalancing premium.

This rebalancing mechanism can be constructed in a number of ways, but a thoughtful design may help investors capture the rebalancing premium without incurring unnecessary risks or predictably costly portfolio turnover. Since 2005, Research Affiliates has used accounting metrics – particularly cash flow, dividends, book value, and sales – to fundamentally weight index portfolios, seeking to turn the return drag of cap-weighted benchmarks into a return advantage for our RAFI indices. We apply the same key design elements of the RAFI Fundamental Index to the RAFI ESG US Index.

By weighting and rebalancing ESG stocks based on their fundamental size rather than market capitalization, the RAFI ESG US Index aims to avoid the return drag associated with overweighting more expensive ESG companies and underweighting cheaper ESG companies. As Figure 1 shows, RAFI ESG’s fundamental weighting results in what we deem to be cheaper valuations than traditional market-cap-weighted approaches.

Q: What sets PIMCO RAFI ESG U.S. ETF apart from other ESG index strategies?

Graff: We believe PIMCO RAFI ESG U.S. ETF differs from others in the market in three important ways.

First, as the RAFI name implies (Research Affiliates Fundamental Index), the underlying index strategy weights and rebalances stocks according to the fundamental size of the company, whereas most others anchor on market capitalization weights. Fundamental weighting, in our view, provides greater potential for excess returns. We believe the RAFI ESG US Index’s systematic contrarian rebalancing provides a clear point of differentiation, seeking more attractive valuations in comparison to cap-weighted ESG strategies.

Second, the RAFI ESG US Index supplements traditional ESG metrics with financial discipline and diversity measures – both of which are linked to good corporate governance and may be expected to improve returns.

Lastly, RAFI ESG US Index is one of the few equity ESG index strategies that excludes fossil fuels and screens out oil and gas companies. Other ESG strategies have been slow to reduce exposure to fossil fuels and may contain exposure to “big energy” stocks. As Figure 2 shows, RAFI ESG US Index has no exposure to oil or gas stocks – unlike other ESG indices.

Research Affiliates has developed a thoughtful approach to ESG investing. We believe that by supplementing traditional ESG measures with financial discipline and diversity metrics, and rebalancing positions using the time-tested RAFI Fundamental Index approach, RAFI ESG US Index and in turn the PIMCO RAFI U.S. ESG ETF offer investors the potential for long-term outperformance of the broad market.

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