The small cap sustainability opportunity
Large cap biases, rating inefficiencies and the exciting opportunities they bring for small caps.
The prolific expansion of ESG investment products has overlooked a major asset class: small caps.
Their large cap counterparts boast higher ESG scores and dominate the portfolios of ESG funds. We think this size bias appears unwarranted and leaves small caps poised for significant upgrades to their sustainability scores. In our view, this should lead to broader recognition of small caps by the marketplace and meaningful relative outperformance.The typical ESG-minded investor tends to assess a company’s ESG profile through reports from rating agencies MSCI and Sustainalytics. A higher MSCI score implies stronger ESG characteristics, while a lower Sustainalytics score implies fewer ESG risks. The chart below shows that as market cap increases, both MSCI and Sustainalytics scores improve.
Compared to small caps, large cap companies experience on average a 32% better MSCI score and an 18% better Sustainalytics score. Large cap companies are defined as those with market caps above $50 billion; small caps as those between $250 million and $15 billion.
The bias explained
The correlation between score and size is not surprising. Sustainalytics and MSCI scores are driven primarily by disclosure and policies. Larger companies are better equipped than smaller ones to report on ESG metrics. Many have dedicated sustainability teams or onboard consultants. This is in stark contrast to small caps, which often lack even a standalone Investor Relations professional. Employees frequently wear multiple hats and take on a variety of capacities not reflected in their job title. Our team has engaged with small cap companies that have strong, sustainable business models but lack dialogue with the major rating agencies.
Partitioning an MSCI score into its E/S/G pillars reveals some insight into the dynamics that drive a bias towards larger companies. The chart below shows that while environmental and social scores increase directly with market size, governance scores do not. This is likely because governance is the most standardised dimension of ESG. Widely held beliefs about what constitutes good corporate governance were formalised by the Cadbury Committee in the UK three decades ago. Unlike social and environmental metrics, investors strongly agree on expected governance disclosures, which include board composition, remuneration, ownership structure and business ethics, to name a few. Governance metrics are quantitative, easy to grade and widely accessible without any reliance on ESG rating agencies.
A medical equipment company trying to improve its ESG characteristics told us it is clear on what the common denominators are for good governance but cannot find consensus on what E & S outcomes investors prefer. This ambiguity creates a landscape that is very difficult for small caps to navigate. Lack of clarity also creates assurance concerns. The medical equipment company mentioned a reluctance to report on E & S figures it could not adequately audit or consistently measure.
Thorough and responsible ESG reporting is costly and smaller firms suffer as a consequence. This medical equipment company highlighted the opportunity cost of bringing on additional headcount to report on ESG as opposed to having each incremental hire fully focused on delivering for their stakeholders (which is, ironically, the objective of sustainable investing). With concerns of greenwashing abounding and limited resources and time, it’s understandable why small caps may err on the side of caution. We look to identify small caps, like the one in this example, that sincerely care about ESG but need to do a better job externalising their sustainability characteristics.
Large cap concentration in traditional and ESG funds
This inherent bias in ESG ratings feeds into a tilt towards large cap in ESG funds. The table below shows that the weighted average market cap of a holding in the five largest ESG funds is $401 billion. This includes both indexed and actively managed funds. The three funds that lean towards smaller companies are all energy thematics. While small caps are recognised for their role in the energy transition, they remain underappreciated for their contribution to other sustainability themes such as health and wellness and inclusion. It’s worth noting that while there is a difference between funds that explicitly embed ESG risks and opportunities versus those that consider ESG characteristics, a bias towards large companies is present for both categories.
Largest ESG funds by AUM (fund names anonymised)
Looking under the hood, it’s almost impossible to separate a traditional US equity fund from an ESG-labelled fund.
The table below shows that, with the exception of Meta, ESG funds hold the same securities as traditional indexes – large and mega cap companies, whose average MSCI score is 6.6 (‘A’ rating). Ironically, size seems to matter more than score, given Amazon and Alphabet are among the largest positions in traditional and ESG funds but rank in the bottom 30% and 10% of S&P 500 ESG scores, respectively. ESG funds contain fewer concentrated positions – the top 10 names account for 15% versus 28% in traditional funds – but retain their focus on large companies.
For the purposes of the below analysis we used ETFs. The “traditional funds” included the 10 largest US ETFs by assets under management (AUM), while the ESG funds were the 50 largest ESG ETFs by AUM, as defined by fund title and strategy, scrubbed for accuracy.
Position size here is the average stock weight across the fund universe, calculated as total dollar amount in the stock / total dollar amount of the fund universe. Position rank is the overall stock position within the fund universe, defined by position size sorted in descending order.
The companies mentioned are for illustrative purposes only and not a recommendation to buy or sell.
Small caps, small seat at the table
From speaking with small cap companies, we get the sense that their ESG efforts aren’t always recognised by the rating agencies. For example, a small biopharmaceutical company scored 0 from Sustainalytics for Product & Service Safety, Drug Promotion Standards and Access to Medicine Programs. To address this poor score, the company published bioethics and patient and product safety policies in April 2022. It notified Sustainalytics upon the release and through additional follow-ups, yet its score has not changed since October 2021 and it still hasn’t heard back from the rating agency. If the biopharma company’s new policies were fully recognised by Sustainalytics, its score would increase 22.5 points (+54%), shifting its overall ESG risk assessment from ‘Severe’ to ‘Low’. This is a significant improvement that would likely alter investor perception of the company’s risk and increased appetite for the stock.
A purely quantitative approach to ESG investing has resulted in an unintended – but consequential – inefficiency within small caps. We believe it’s very difficult for passive, best-in-class strategies to capture long-term ESG alpha given the lack of certainty that can be extrapolated about a company based on its ESG rating.
Our differentiated approach
Through a holistic active management approach, the Schroders US Small Cap team looks beyond traditional ESG ratings.
Schroders’ proprietary tool, SustainEx*, systematically measures a company’s positive and negative impact on society and exhibits a near-zero correlation between score and company size (see chart below). This model-based assessment can be used to re-focus portfolio construction around quantitative measurements of sustainability and unpriced social and environmental business risks. This framework encourages (or rewards?) companies for having more internal discussions centred around product externalities and stakeholders.
Carbon VaR, another Schroders proprietary tool, estimates the impact of climate pricing on a company’s financial profits. Unlike simple carbon footprints, which do not capture underlying investment risk, Carbon VaR quantifies climate change transition risks effect on profitability. This model incorporates carbon emissions, but also takes into account profit margins, industry-level price-elasticities of demand and carbon pricing scenarios.
Models like SustainEx and Carbon VaR, used alongside fundamental analysis, enable a deeper dive into sustainability. Internal ESG efforts ought not be rejected or discredited; however, one needs to look no further than MSCI’s ‘A’ rating of Chevron and ‘BB’ rating of the aforementioned biopharmaceutical company to appreciate that ESG scores do not tell the full story about a business.
Conclusion: clear inefficiencies bring clear opportunities
In summary, we find that traditional sustainability ratings bias towards large companies. This is primarily due to the complexity of the ESG landscape and that large caps have more resources to report on ESG metrics and engage with ESG rating agencies. Large caps dominate concentration within ESG funds. In fact, it can be nearly impossible to distinguish between a traditional equity fund and an ESG-labelled fund.
Talking with small cap companies and digging into what drives their poor ratings, a clear inefficiency emerges. Small caps’ sustainability profiles are significantly discounted by the market. The small caps that better articulate their sustainability characteristics should benefit from the well-documented ‘green premium’ that this asset class has yet to fully experience.
This presents exciting opportunities in the small cap space, specifically around two dimensions:
1) A greater opportunity to identify misunderstood or under-appreciated companies that will re-rate higher due to strong underlying ESG characteristics
2) The opportunity to engage and partner with companies on their sustainability journey to help drive broader, deeper impact on stakeholders.
We believe these factors will generate meaningful alpha over the long-run.
*Schroders uses SustainEx™ to estimate the net impact of an investment portfolio having regard to certain sustainability measures in comparison to a product’s benchmark where relevant. It does this using third party data as well as Schroders’ own estimates and assumptions and the outcome may differ from other sustainability tools and measures.
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The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.