ESG investing is surging so much it is now becoming mainstream. This trend is only expected to continue its momentum in the new year with the change in presidency and the continued support from the masses, mainly millennials, due to the numerous proven benefits of employing an ESG investing strategy.
Currently, ESG investments account for more than one third of all assets under management in the US. Much like the rest of the market, the trend has been precipitated by the rise of ESG ETF investing. In fact 80% of ESG investing is done through these passive index funds. In its most simplistic form, this passive investing style allows for broad exposure to companies scoring well on ESG parameters. There are now hundreds of ESG ETF products available in the US with that number expected to continue to grow due to their high demand. In fact in 2020 alone, investments in ESG ETFs have more than doubled from 2019 levels.
At first glance this is positive for the proponents of ESG, sustainable investing, and impact investing. However as we look further into the trend of passive index ESG investing, we start to see some troubling patterns.
What are ESG ETFs?
Before we dive too deep into ESG ETFs, let’s look into exactly what they are. ETF stands for Exchanged Traded Fund. Much like other securities these funds can be bought and sold on the market. ETFs are collections of securities (stocks of companies) that track an underlying index. There are a variety of different variations of these “bundles of stocks” available for purchase. They can be organized by sector, size, region, or countless other themes.
ESG ETFs are collections of securities that track companies with positive ESG scores. These ETFs can be grouped in a variety of ways to give individual investors a “sustainable and socially responsible” investment option. There are exclusionary ESG ETFs. Exclusionary funds simply avoid “sin stocks” (tobacco, weapons, oil, etc.) and group other stocks that will follow the general market of “less harmful” sectors. These funds typically mirror market-based index funds such as the S&P 500, but exclude companies that score negatively on ESG factors. There are also more specific ESG ETFs, such as thematic ones, which are organized around a specific theme or mission statement individual investors may want to support and invest in. For example, investors who care about the environment (the “E” of ESG), or renewable energy more specifically, may be inclined to invest in iShares Global Clean Energy ETF (ICLN) or Invesco Solar ETF (TAN). There are numerous thematic ESG ETFs that track a multitude of themes, values, and sectors that investors care about and may want to invest in.
To find out more about the specific parameters that go into creating each of these funds, investors would ideally look through each fund’s prospectus. As Theresa Gorman, Chief Investment Officer at First Affirmative Financial Network explains, “the proliferation of data has made it far more difficult for individual investors to determine if a fund or ETF meets their impact preferences. They should look at prospectuses in light of these questions.”
The downside is that a prospectus can be long and complicated, and most investors just assume fund managers are well-intentioned if they like the name and the funds’ largest holdings. Discrepancies between the intent of the investor and the true impact of the ETFs that they are investing in are very difficult to catch.
Unpacking ESG ETFs
To dig deeper into this inconsistency let’s peel back the holdings of a popular ESG ETF using UnifyImpact’s rankings. Blackrock’s iShares ESG Aware MSCI USA ETF (ESGU) is one of the larger and more well known domestic ESG funds.
ESGU trades on the NASDAQ and comprises 12.7 billion USD in net assets. Its fund summary states that “the underlying index is an optimized index designed to reflect the equity performance of U.S. companies that have favorable environmental, social and governance (“ESG”) characteristics (as determined by the index provider), while exhibiting risk and return characteristics similar to those of the MSCI USA Index (the “parent index”).
Wow! That is confusing. Does it mean this fund invests in companies that are generally good for the environment, socially responsible, and well-governed? What exactly goes into that criteria and what companies qualify? And does any of that necessarily align with what I care about?
The first step towards finding out is to understand the holdings of the fund. Let’s take a look at some of the companies included in ESGU. The largest holdings are familiar to anyone who follows the market. They include Apple, Microsoft, Amazon, Alphabet and Facebook from the tech sector, Tesla from the auto industry, and large corporations such as Johnson & Johnson and Procter and Gamble.
Let’s say Susy invests in ESGU because she is passionate about Climate Change and Diversity and is looking for an ESG fund to match those values. Well, Susy will be happy with some of her new holdings when it comes to Climate Change (TSLA 5.9 and JNJ 6.9), but less so with their Diversity scores (TSLA 3.9 and JNJ 3.8). Furthermore, she will be very unhappy with Facebook’s inclusion in the index considering their lowly 3.0 overall ESG impact score and their 2.7 on Climate Change and 3.1 on Diversity. Just looking at a couple of the holdings in this ETF, we see a serious lack of direction when it comes to ESG values. It is very unclear whether the true impact of Susy’s investment in ESGU aligns with her individual values.
Surprisingly under further examination, over 5% of the holdings of the ESGU fund are major fossil fuel producers and consumers, including Exxon Mobil and Chevron, companies which are notorious for having a negative impact on the environment. Even though the ESGU index is supposedly focused on excluding sin stocks, the fund managers are clearly not too strict about their mission. Surely there has to be more to ESG investing than these broad indexes?
In general, there is a lack of clarity, transparency, and purpose in many popular ESG ETFs. Gorman continues, “nobody does a great job of analyzing sustainability at the fund level. You’d be surprised at how different the scores could be from each vendor.” Not only are we seeing discrepancies in the ESG scores of some of the holdings of these index funds, but investors are not necessarily getting the impact that brought them to these offerings to begin with. The themes can be so broad they become irrelevant. Investors who deeply care about Climate Change would most likely have different opinions from those who care about Community and Leadership. Despite the proliferation of ESG ETFs, chances are few of them are well-equipped to handle both your financial goals and ESG investing values.
Losing Your Shareholder’s Rights
Misaligned and poorly targeted values are not the only shortcoming of ESG ETFs. Those who invest in funds rather than individual companies are also giving up their shareholder’s rights.
One of the most important ways investors can make an impact on the world via sustainable investing is through shareholder advocacy. When you invest in a company, you have a right to vote on company issues at the company’s annual meeting and via proxy voting. This includes voting on issues that relate to ESG factors. However in these passive ESG indexes, oftentimes the fund manager does not utilize this right and advocate for specific issues that individual investors care about. When the investors are passive and everyone is making money, it is easy to forget the values that led you to a certain fund in the first place.
A more holistic and effective ESG investing strategy includes knowing exactly which companies you are investing in, and exercising your shareholder’s rights where you can.
UnifyImpact has entered the market to democratize ESG investing for retail investors. With UnifyImpact’s platform, users are able to glean insights on individual company’s ESG rankings based on personal impact values. This gives investors like you more confidence to make educated and purposeful mission-aligned sustainable investments. Whether investors come to UnifyImpact to investigate the holdings in their current ESG ETFs or want to double-check individual company rankings on specific impacts before purchasing stock, users will have never-before access to approachable and customized ESG rankings, information, analysis, and news.
For those looking to invest sustainably and overcome the shortcomings of passive ESG index investing, sign up for up-to-date ESG scores on 20,000 public companies giving you the confidence to align your assets with the impact values that matter to you.