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Wall Street Journal / Biz - Money

How These Investors Saw Facebook’s Privacy Scandal Coming

When Facebook’s share price tumbled last month following reports that a U.K. consulting firm had improperly obtained profile information of 87 million users, many investors were stunned.

A television on the floor of the New York Stock Exchange displays a live feed of Facebook CEO Mark Zuckerberg as he testifies before Congress on April 10. A handful of funds that pick stocks based on good governance scorecards weren’t surprised by the latest developments at the social-media company.

When Facebook Inc.’s FB -1.08% share price tumbled last month following reports that a voter-profiling firm had improperly obtained profile information of tens of millions of users, many investors were stunned.

But a handful of funds that pick stocks based on good governance scorecards weren’t at all surprised. They were forewarned by index provider MSCI Inc., MSCI -0.27% whose analysts wrote in a June report that Facebook was “exceptionally vulnerable” to backlash from users and regulators because of its focus on “monetizing personal information.” In fact, MSCI has singled out privacy practices as one of its biggest risks since Facebook went public in 2012.

Facebook is down 6.8% this year, and those funds are beating major U.S. stock indexes in part because they owned smaller-than-usual slices of the beleaguered social-media giant, or avoided it altogether.

Of course, any investor who steered clear of Facebook because of MSCI’s caution would also have missed the stock’s huge gains: The share price has quadrupled since going public.

Facebook offers a look at both the strengths and limitations of picking stocks based on how well companies perform based on environmental, social and governance criteria, known by the clunky acronym ESG.

“You’re taking the risk of missing out on short-term supernova performance gains, but you’re trying to insure your portfolio against companies that are liable to implode,” said Martin Kremenstein, head of retirement products and ETFs Nuveen, the asset-management arm of TIAA.

Nuveen is among a growing number of firms selling funds that pick stocks based on ESG criteria. Some money managers use ESG scores to help pick stocks, while others, like Nuveen, BlackRock Inc., and Oppenheimer Funds, sell funds pegged to ESG indexes. Research Affiliates LLC, the Newport Beach, Calif., asset manager founded by investing pioneer Rob Arnott, launched its own ESG strategy this month.

Proponents tout it as a feel-good way to beat the competition by sidestepping potential pitfalls like Facebook. These loosely defined strategies tilt their portfolios based on how well companies score on issues like board independence, toxic emissions or workplace safety.

The concept is popular in Europe and Asia, particularly among big investors like pension funds and insurers, and it’s catching on in the U.S. Money managers and institutional investors applied ESG criteria to $8.1 trillion in U.S. assets in 2016, an almost 31% increase from 2014, according to a report from U.S. SIF, the Forum for Sustainable and Responsible Investment. The organization is currently collecting data for 2018.

It’s an offshoot of socially responsible investing that attempts to systematically evaluate businesses instead of just excluding unlovable industries. To come up with the ESG ratings, analysts from firms including MSCI, Sustainalytics and Thomson Reuters Corp. scour news stories, financial records, regulatory filings and company reports looking for hazards that traditional financial analysis might miss. Each firm is assessed on the key risks facing its industry, and those results feed into the overall rating.

Some notable successes include Equifax Inc., which in August 2016 was ejected from a family of MSCI indexes because of data-security lapses. A year later, Equifax disclosed a massive breach that sent its share price tumbling. And MSCI downgraded Wells Fargo & Co.’s ESG score in November 2015, noting a high level of customer-service complaints, months before the company was fined for “widespread illegal” sales practices.

Whether those judgments will translate to better returns over the long haul isn’t entirely clear, in part because there’s no fixed definition of what constitutes an ESG fund. There’s evidence that such strategies may lag hot stocks during a runaway bull market, but will be more resilient in a downturn, said Mr. Kremenstein of Nuveen.

Take Nuveen’s 16-month old NuShares ESG Large-Cap Growth exchange-traded fund. The ETF invests in companies that get the highest ESG scores from MSCI, so it has never owned Facebook. Last year, as Facebook shares surged 53%, the NuShares fund lagged behind the iShares Russell 1000 Growth ETF, which counts Facebook as its fourth-largest holding, according to FactSet.

So far this year, the NuShares ETF has returned 4.3%, while Blackrock’s iShares growth fund gained 1.9%.

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