Contrarian Investors: Buy the "ESG Orphans" with this ETF

"What is the thesis against ESG investing as you see it?"

MN: "The jumping off point in my research was an article by Cliff Asness called: Virtue is its own reward: One Man’s Floor is Another Man’s Ceiling. He talked about capital constraints, misallocation of capital, higher expected return securities (the exclusions), and concluded: 'An ancillary consequence of ESG investing is lower returns'."

"Academics support my thesis. The price action does too. As flows leave ESG and move back towards all stocks, the ones excluded (my ESG Orphans) screen as cheap on a relative basis (and on an absolute basis in some cases) and are very under-owned, uncrowded versus the accepted ESG names."

"What makes your security selection process unique?"

MN: " There are other so-called 'anti-ESG' funds out there, but those are really sector funds with some association to 'anti-ESG'. For example, BAD and VICE are mostly drug, alcohol, and gambling-related ETFs. They move with those sectors more than ‘anti-ESG’ factor per se. There may be “anti-ESG” associated with each of these ETFs, but it’s not their unique factor."

"But ORFN is the unique “anti-ESG” ETF. I isolated the ESG factor across all sectors after reading hundreds of ESG fund prospectuses and screening thousands of stocks. By doing so, I was able to find the specific sectors/stocks excluded across the entire ESG universe when creating my basket. Again, the other funds picked a few sectors, but did not isolate the actual ESG/ex-ESG factor in its entirety."

"ORFN did comparatively well last year. Which sectors, industries, and/or securities contributed to this?"

MN: "Clearly energy was the standout in 2022. XLE gained 64% and with ORFN having a 25% allocation to energy, that was a major contributor. Tobacco names also did well as a group, boosted by big dividends from PM, MO, and BTI. At 12.5% of ORFN, the dividends provided income and stability as well as some noncorrelated diversification."

"The defense industry (21% of ORFN) saw big inflows as Ukraine purchased weapons from some of the ESG Orphans like LMT, RTX, NOC, GD, and BA. The diversification within ORFN across the six sectors we isolated allowed for unique return attribution. This, along with the focus on “under-owned” securities helped target better risk-adjusted return opportunities over time."

"Do you think there is an alpha creation opportunity due to how ESG considerations have shifted the natural allocation of capital?"

MN: "There is absolute alpha creation in ORFN. It’s nearly irrefutable. The basket carries a 0.80 beta to the SPX. The SPX was down 20% in 2022. The ESG Orphans Index (ORFN tracks this but only launched in mid-May) was up 20% in 2022. The beta suggests the ESG Orphans Index should have been down 16% instead of being up 20%."

"To put it in an ETF performance context, ORFN launched in mid-May and returned 4.93% in price (not including approximately 1.5% in dividends) versus SPY’s -2.40% in price (plus approximately 0.80% in dividends). That was around seven months’ worth of better than 7% alpha generation. I expect this type of repricing reallocation to occur in the coming years."

"Thank you for your time and insights Mark. Do you have any closing comments?"

MN: "The ESG pushback is growing, investment mandates are broadening, and investors are looking more widely at investable securities. This means stocks and sectors that have been excluded heretofore will now be included as investable. For some further reference and reading, you can find my year-end recap and 2023 outlook here."

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.