The 'ESG' Umbrella Has Leaks

Most of the time, we think about our investments in pretty simple risk/return terms, and generally in reference to some benchmark.

Treasuries? Lower risk, lower potential return than stocks.

Emerging markets? Higher risk, higher potential return than the S&P 500.

Even if we don’t label everything in the style box with risk and return, the growth/value and small/large cap axes we’re used to seeing from our friends at Morningstar carry with them a clear assumption: Small-cap growth is probably riskier, and has a bigger potential, than large-cap value.

But when you get to environmental, social and governance (ESG) investing, things get a lot more complicated. All of these risk/reward issues—capitalization, industry concentration, growth/value, beta—still matter. But now you have to consider the “ESG-ness” of your strategy.

Next week I’m hosting a webinar with Richard Cea from InsightShares, and one of the slides he submitted highlights this beautifully:

Broad & Narrows Focuses

The idea above is actually pretty simple: At the core, every ESG idea either has a broad market approach, or naturally narrows in on particular geographies or industries. A clean energy fund, for instance, is going to be light on fossil fuel stocks.

Each strategy also makes certain choices about how pure it’s going to be—are securities “in or out”? Or are there just shades of relative gray, tilting the fund in a certain direction?

Where a given ESG strategy falls on these axes has implications for risk and return—the most absolute, sector-specific strategies can be undiversified, and thus riskier—but also have real implications for how “pure” a given approach is.

Understanding what you want out of your ESG investment on these two axes is critical, but perhaps nowhere more so then when we think about the “S” in ESG.

Defining ‘Social’

Under this umbrella, one could lump all sorts of funds, which either internally have rules designed to achieve a desired societal or cultural outcome, or which, by their very nature, may fit a particular world view. But historically, the “social” part in ESG is not the part most companies are targeting with their efforts.

Defining Socially Conscious

Simply put, there’s far less consensus for what it means for a firm to be “socially conscious” then there is for it to be “environmentally conscious.”

Probably the easiest-to-understand category of “socially conscious” funds are those designed to be compatible with a particular religious viewpoint, like the Inspire 100 ETF (BIBL), or the Global X S&P 500 Catholic Values ETF (CATH), which explicitly invest based on Christian biblical principles. But there are many, many ways to think about this kind of investing (we track over 65 funds that broadly wedge into the theme).

Some of these conveniently label themselves “ESG” in the title, but a lot of them don’t, and whether or not a given fund belongs in this “social” bucket says more about you than it does about the funds in many cases.

ESG Blind Spots

Global warming on your mind? Then funds like the Guggenheim Solar ETF (TAN) or the PowerShares Cleantech Portfolio (PZD) will be on your list. But those funds aren’t explicitly trying to change the world with investment dollars, they’re just subindustry funds.

Maybe, for you, it’s about geopolitics. In that case, the WisdomTree Emerging Markets ex-State-Owned-Enterprises Fund (XSOE) will be top of mind.

And of course, there are plenty of funds that seek to simply reward good corporate citizenship, whether it’ companies that are proactively “doing good” or simply companies that are seen to “do no harm.”

These funds range from those targeting companies with strong diversity (the Barclays Women In Leadership ETN (WIL)) to those focused on firms pursuing the U.N. Sustainable Development Goals (the iShares MSCI Global Impact ETF (MPCT)).

Alphabet Soup?

One of the great things about ETFs is that they make dissecting investments easier. Because so many ETFs are index-based, they naturally lend themselves to a neat and orderly classification.

That’s why Elisabeth Kashner from FactSet and I had so much fun developing the ETF Classification System that drives our ETF Finder.

But reality, as always, is pretty messy, and in corners of the market like “ESG” investing, we can become captive to our own acronyms and structures.

There’s not actually any logical reason why a fund investing in industrials and tech firms focused on solar panels belongs in the same bucket as a fund focusing on veterans, or focusing on labor standards, but that’s where the global investment management industry has ended up.

This year, I want to focus on tearing apart these overbroad buckets. We’ll start next week in a one-hour session with InsightShares’ Richard Cea to dig deep into the “S” in social, and look at how different social “factors” can have a pretty dramatic effect on your portfolio. I hope you’ll join us. Click here to register.

You can reach Dave Nadig at [email protected].