ESG Is Finally Making its Way to Smaller Stocks

Traditionally, environmental, social and governance (ESG) investing is dominated by large-cap equities.

For example, components in the S&P 500 ESG Index had an average market capitalization of nearly $78 billion at the end of last year. Add to that, the universe of passive funds, including exchange traded funds, dedicated to mid- and small-cap stocks that score well on an ESG basis is currently small. That's not a knock on the combination of ESG and the size factor. It's just the current lay of the land and the reasons why ESG has yet to earnestly permeate mid  and small caps are easy to explain.

“Small- and mid-sized companies have less public information and, given the lack of disclosure versus large-cap companies, reliance on ESG data from third-party providers may lead to an incomplete picture that would penalise these smaller companies,” said Anna Lundén, Managing Director, Equity Portfolio Manager at Wellington Management, in an interview with Nordic Sustainable Investments.

Indeed, many large- and mega-cap companies not only prioritize ESG principles and plenty deliver the goods on this front. For advisors and clients looking to apply ESG to smaller stocks, there's good news: Index providers are evolving.

Real World Examples

The S&P MidCap 400 and S&P SmallCap 600 indexes are two of the most widely followed benchmarks dedicated to smaller stocks, making both fertile territory for ESG application. That process is finally coming to fruition.

“This positive correlation between ESG performance and firm size means that the standard ESG score exclusion criteria would likely result in an eligible universe that is simply too narrow to maintain a broad and diversified index,” according to S&P Dow Jones Indices. “To remedy this, we apply minor adjustments to the methodology for the 400 and 600 versions to ensure the indices can satisfy the S&P ESG Index Series objective.”

As is the case with the large-cap S&P 500 ESG Index, apply ESG to the pair of smaller equity benchmarks whittles down the rosters. With ESG in the mix, the MidCap 400 has 274 components while the small-cap index declines to 407 constituents.

“This result, coupled with an almost identical underlying factor exposure to their benchmarks (even when it comes to size, surprisingly) confirms that these new ESG indices are poised to do precisely what they are intended to do,” notes S&P Dow Jones.

For client portfolios, these adjustments are palpable. The S&P MidCap 400 ESG Index outperforms its non-ESG counterpart by 1.09% on an average annualized basis over the past decade while the ESG small-cap benchmark beats its non-ESG peer by 1.33%  on an average annualized basis.

What's Next

Given the brand recognition and following of the S&P MidCap 400 and the S&P SmallCap 600, it's fair to say ESG ETFs linked to those benchmarks will eventually come to market.

Still, we're talking about fewer than 700 stocks across the two ESG indexes, meaning smaller companies need to meet index providers halfway and prove their ESG mettle.

“For small-cap companies, now might be the time to start understanding ESG, speaking to your largest investors about it, and discussing it in board meetings,” according to the Small Cap Institute. “Companies that can show investors they are ahead of the issue — reducing climate-related risks in supply chains, upholding strong governance norms, and reducing workplace inequality, for instance — will likely fare better when investors start asking questions.”

With so many advisors already embracing ESG strategies – meaning billions of dollars are flowing into related funds – expect more mid- and small-cap firms to up their ESG games with eyes on entry into relevant indexes.

Related: How Advisors Can Address Sustainable Investing With Clients