Environmental, social and governance investing resonates with people who want their investments to align with their values, and the boom in this investing style has fund companies launching more ESG investment vehicles.
But these funds may not be as green as investors think they are.
ESG investing considers both financial return and social and environmental good. But just as investors can disagree on where to draw the line between value and growth investment styles, they can come to different conclusions about how well companies are delivering in these areas. There are no U.S. nor global standards.
As a result, ESG investing comes in different shades of green. Traditionally, ESG investing was done by active managers at fund firms with decades of conducting their own research in sustainability, gathering data and creating deep investment processes. They press companies to become more sustainable and seek better corporate behavior. These early adopters are among the deepest green of ESG portfolio managers.
The rise of passive-index ESG investing, however, has added more green variations. With these funds, the asset managers set their ESG goals and work with an index provider to create the strategy. The outside firm does the analysis and creates the rules-based methodology; the fund family licenses the index.
Regardless of the strategy, the fund manager still decides how hard to push companies on ESG goals. He or she may or may not vote in favor of ESG measures or advocate for sustainability. Fund families operating the lightest of the light-green funds incorporate ESG factors on a limited basis and aren’t activists.
Shades of green
There is some debate among industry insiders whether light-green, also known as “light-touch,” ESG funds are more about marketing than sustainability. Using ESG data in a limited way isn’t “greenwashing” — saying something is sustainable when it’s not — since asset managers post each fund’s goal and ESG criteria on websites and go deeper in prospectuses. But not every investor takes time to read those prospectuses. And it takes time to read up about an asset manager’s shareholder advocacy.
A fund’s shade of green matters if an investor thinks their ESG fund has a strict strategy to affect change and the management purses those goals. Others may be fine that their fund is just limited to a portfolio of high ESG-rated companies. Either way, investors need to look beyond the fund name to understand how the mutual fund or ETF approaches ESG; the broader investment style now accounts for one-third of U.S. assets under professional money management.
Review the investment criteria
To begin determining if an ESG fund is a light-touch fund, look at its investment criteria. Sometimes ESG funds that also want to mimic broader stock-market index returns have to balance between owning the higher-ranked ESG stocks in a particular industry and choosing some names that might surprise socially conscious investors, says Todd Rosenbluth, director of ETF research at CFRA.
He used one of the biggest ESG ETFs by assets under management as an example: the $12.9 billion iShares ESG Aware MSCI USA ETF ESGU, +0.44%, which chooses companies with strong ESG traits while still looking like a traditional market index.
While the ETF screens out controversial weapons, tobacco, shale energy and fossil-fuel reserves, it has 5.5% of its assets are fossil-fuel producers or consumers, including Exxon Mobil XOM, -0.91%, Chevron CVX, -1.03% and Exelon EXC, +0.69%, according to a screen from As You Sow, which rates ESG mutual funds and ETFs.
“By being sector-neutral, you are going to have energy and you are going to have utilities, two sectors less-likely to be environmentally friendly. They may or may not be environmentally friendly, but they have strong governance or social characteristics,” he says.
Asked to respond, iShares media relations referred to a quote in a news release describing its suite of various ESG ETFs. “Sustainable investing was historically a values-based exercise –it has evolved into an investment risk and performance-based decision…. Our product framework delivers clarity and options for clients to help achieve their investment objective(s),” says Armando Senra, head of iShares Americas.
Another broad-based ESG ETF, the SPDR S&P 500 Fossil Fuel Free Reserves Free ETF SPYX, +0.66%, has 5.3% of its $839 million in fossil-fuel producers or consumers, including a small holding in FirstEnergy FE, +1.66%, a coal producer.
Matt Bartolini, head of SPDR Americas Research, says the SPDR suite of fossil-fuel-free funds is a rules-based approach to divest from companies with proven fossil-fuel reserves in high carbon-producing industries. It tries to balances an investor’s environmental interest with a financial return similar to broad-based benchmarks.
“Eliminating all firms that interact with carbon would result in a heavily concentrated portfolio that may not be suitable for all investors. As a result, there is a small exposure to firms that may interact with carbon, but do not have proven reserves – consistent with the intended investment strategy to only divest from firms with fossil-fuel reserves,” he says.
Check the largest holdings
As a second step, investors should consider how these funds fit in their portfolio since the largest holdings can be the same as in broader indexes. Ken Van Leeuwen, managing director and founder of Van Leeuwen & Company, a financial adviser involved in sustainable investing, notes that many of these broad-based ESG funds’ five largest holdings align with the S&P 500 Trust SPY’s top five: Apple AAPL, -0.77%, Microsoft MSFT, +0.33%, Amazon.com AMZN, -0.88%, Facebook FB, +0.47% and the Class A shares of Google parent Alphabet GOOGL, +0.94%, all which happen to have high ESG ratings. Those also are the five largest holdings for ESGU and SPYX.
“You have to think about what are you really buying? You’re just buying tech. Are you diversifying? Are you doing something different is really the question,” he says.
Another big broad-based passively indexed ESG ETF, Vanguard’s $2.8 billion ESG U.S. Stock ETF ESGV, +0.37%, has the same five largest holdings, and screens out some typical industries such as fossil fuels, tobacco and alcohol.
In response, Freddy Martino, spokesman for Vanguard, says: “there are many different methodologies for ESG. It’s important for investors to understand how a particular methodology aligns with their personal preferences.”
The simpler the screens, the lighter the ESG touch
Light-touch passive-index ESG ETFs aren’t always broad-based ETFs. One example is VanEck Vectors Low Carbon Energy ETF SMOG, +0.53%, which offers investors exposure to clean-energy firms such as Vestas Wind Systems VWDRY, -1.09% VWS, +1.95% and Tesla TSLA, +1.57%.
“SMOG can be thought of as thematic exposure to the ‘E’ in ESG,” says Brandon Rakzsawski, director, ETF product development at VanEck. “As an index-tracking ETF, the fund’s portfolio managers seek to replicate, as closely as possible, the price and yield performance of the underlying index and do not actively engage in advocacy.”
Equally, investors shouldn’t assume that all broad-based ESG ETFs are light-touch funds, Rosenbluth says. Again, it comes down to criteria. The simpler the screens, the lighter the touch will be.
He pointed to iShares ESG Advanced MSCI USA ETF USXF, +0.71% as a passive-index ETF that chooses companies with favorable ESG ratings and applies extensive screens to weed out low ESG ratings and companies with severe controversies. Its 10 largest holdings differ from the broader S&P, and as a result, its performance may differ from the main benchmark, he says.
Greg Wait, an adviser at Riverwater Partners who specializes in ESG, says investors can get more information by looking at new ESG research from Morningstar which delves into some firms’ commitments to ESG and individual strategies. The researcher started ranking 40 asset managers and 107 strategies into four ESG categories: leaders, advanced, basic and low. Calvert and Parnassus received top scores, while BlackRock BLK, +1.78% received a basic score and Vanguard received a low commitment score.
Neither BlackRock nor Vanguard offered comment on the Morningstar ratings.
Weigh which factors are most important to you
There are benefits to passive-index ESG funds, whether light-touch or heavier-touch: they are cheaper than active funds and they give investors exposure to firms with higher ESG ratings.
But for investors who want to affect change, they should think about what they want the fund to accomplish and look closely at the strategy, says Graham Sinclair, principal at SinCo- Sustainable Investment Consulting, a sustainable business consultant. That includes what the fund underweights or overweights relative to its category, the process to reevaluate a holding if an ESG risk affects the company, and the process to divest if necessary.
ESG investors also may need to consider what’s most important them because not every company excels at sustainability across the board, Sinclair says. Tesla, for example, ranks high on environmental criteria, but scores terribly on labor issues for its widely reported problems with workplace healthy and safety.
Possible changes for 2021
The new year will bring a greater industry push toward more company transparency and possible standards on ESG at both the fund and company level.
The CFA Institute is developing voluntary ESG disclosure standards for investment products them more friendly to retail investors. The Investment Company Institute, an industry trade group, is also pushing for more robust corporate disclosure.
Additionally, both BlackRock and State Street STT, +1.22% said in 2020 that they would use votes at shareholder meetings to push for corporate ESG practices.
Read: The fund-management industry wants better ESG disclosure — here’s what it says Biden should do
Market participants welcome more transparency and standards, but both Rosenbluth and Sinclair say to some extent the push for standards may be overblown. ESG investing is a style, like growth or value, and there are no standards on those definitions, they say.
“We’ve had this same issue when comparing growth versus value. How can someone say Microsoft is a value stock and someone say it’s a growth stock? It still comes to caveat emptor. Check what’s on the label and actually read the prospectus,” Sinclair says.
Debbie Carlson is a MarketWatch columnist. Follow her on Twitter @DebbieCarlson1.
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