Part small-cap, part mid-cap, part ESG—the task of managing Thrivent Small-Mid Cap ESG ETF (TSME) is a bit like unscrambling a Rubik’s Cube.

“An important part of our investment process,” explains Charles (Chad) Miller, senior portfolio manager, “is analyzing the various ESG issues each company is involved with and the strategies that play into these topics—while also directly attaching this to our fundamental research analysis.”

Miller, along with Matt Finn, head of equities, limits the portfolio to a select mix of approximately 60 small- and medium-sized stocks with attractive valuations that have demonstrated a commitment to environmental, social and (corporate) governance (ESG) initiatives and sustainable business practices.

Miller leans on Thrivent’s experienced small- and mid-cap portfolio management teams to help shape the portfolio. “We're able to leverage the unique experience and knowledge that our investment team brings to the table—from our deep pool of investment analysts to our portfolio management teams,” he said.

For Miller, bringing ESG standards into the mix adds a whole new dimension to managing the Fund. The lens under which stocks must be analyzed expands, while the universe of prospective holdings contracts. Adding to the challenge, ESG research data is still limited, particularly in the small- and mid-cap sectors.

“One of the biggest challenges with an ESG fund today is that the disclosure around ESG topics is still evolving and improving over time,” said Miller. “And so, there are specific challenges on trying to figure out information we would love to know in our investment process.”

That’s another area where Miller believes Thrivent has an advantage as a long-term investor in the small- and mid-cap space. “Where there are ESG issues that might not be completely covered with current disclosures, we can reach out and engage with the company to get a better understanding of the steps they may be taking that have not yet been picked up by the ESG reporting services. So, the ability to engage and partner with companies in deep, long-term, meaningful conversations is an advantage for us in making up for the lack of disclosures of ESG data.”

Assessing ESG strengths

Sifting out promising ESG stocks takes a little extra effort in confirming the company is appropriately addressing ESG issues, ascertaining that the company has a viable business plan with solid prospects for growth and that both of those pieces fit neatly together.

In his analysis, Miller breaks down each company’s ability to address what he considers to be the six primary stakeholders: the environment, employees, customers, suppliers, community and corporate governance policies and procedures.

“This helps us identify potential opportunities in a business model and the specific points of differentiation,” said Miller. “If our research indicates the company is doing a particularly strong job in any one—or, ideally—several of these categories, this helps us formulate a picture of what its competitive advantage really is going forward.”

For instance, in the environmental area, Miller and his team assess each stock by paying particular attention to how the company is impacting the natural world around it—and what strategies it has to reduce that impact over time.

“We're looking for companies that can create emissions as efficiently as possible in the short to medium term and then ultimately reduce those over the long term,” Miller noted. “We're looking for companies that have a strategy to solve water scarcity challenges, consider biodiversity impacts and then also invest in circular business models that create great efficiencies for the environment, as well as the individual companies.”

For example, Miller and his team may assess a company in the health care industry in three key areas—improving outcomes, increasing coverage for underserved individuals and maintaining strong data security and privacy standards. “If we believe the company is improving outcomes and increasing coverage to underserved individuals who otherwise would have gone untreated, we could flow that through directly into our revenue forecast and into our profitability forecast to attach that to our estimate of long-term upside.

“But if we go through all of this,” adds Miller, “and determine that the company is doing all these great things, but they’re already priced into the financial model, then we don't own that company in the Fund.”

Miller also believes it’s important that companies that are pursuing ESG initiatives are doing it for the right reasons.

“Increasingly, we are seeing a growing body of evidence that those companies that do address these topics head-on, try to operate in a sustainable manner, invest in employees and tackle these material ESG issues may also see an improvement in potential performance.”

Working with SASB

The Fund management team evaluates prospective holdings using criteria provided by the third-party ESG materiality framework from the Sustainability Accounting Standards Board (SASB). SASB has worked with stakeholders in various industries to help identify the most financially material ESG issues by industry.

SASB identifies several key areas of interest by industry. “SASB indicates where it believes concerns could show up in a company’s financial statements—if the company has properly addressed a particular category or if it has faltered in that category,” Miller said. “We can tie this directly into our fundamental analysis of the company, feed that into our financial model and ultimately our assessment of the long-term valuation for the company.”

Within the governance category, the Fund focuses on accountability and alignment. “We’re looking for an independent board; we’re looking for effective disclosures,” noted Miller. “We’re looking for ethical conduct, and we’re looking for increased disclosures to help provide the information we want to see in making our investment decision.”

From an alignment perspective, the Fund analyzes areas such as pay practices, long-term investment decisions and capital allocation. “We know the investments that these companies are making today ultimately become our returns in three to four years,” said Miller. “So, we really want to see companies that have a robust process around capital allocation and a right to win in the areas where they’re making investments.”

Sustainability

ESG factors play an important role in investment management to help identify risks and opportunities. 

“From an opportunities perspective, we believe it is helpful to understand what companies are doing to position themselves as a part of the solution to various challenges,” explained Miller. “For example, the world is going through an energy transition driven by regulation, national security and improved efficiency of more recent energy generation sources. Our ability to identify companies that can play a role in this transition and help other companies achieve required targets give us the ability to identify potential opportunities for investment.”

Can focusing on ESG stocks actually improve portfolio performance? While evidence is inconclusive given the brief period that ESG investing has been popular, Miller suggested that incorporating ESG factors in building a portfolio may contribute to strong investment performance for a couple of reasons.

“We know ESG topics are receiving significant attention from executives and boards of directors in shaping company strategies for the coming years,” said Miller. “Based on this focus and implication on company strategy and investment, we believe having a system to engage and analyze the decisions companies are making today will be crucial to identifying opportunities over the coming years.”

He also highlights a growing body of academic evidence to indicate that ESG topics may have an impact on stock performance (see table below).