What ESG Investing Is Meant To Be

What ESG Investing Is Meant To Be

An ETF with ‘ESG’ in the name won’t necessarily align your portfolio with your values.

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Reviewed by: Jessica Ferringer
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Edited by: Jessica Ferringer

ESG-focused and socially responsible ETFs now hold nearly $100 billion in assets, with 76 funds explicitly using the term “ESG” within the name. Google Trends shows more people are searching for the term “ESG” (environmental, social and governance) than for the terms “growth stock” or “value stock.”

There’s no denying that investors are interested in investing in a way that aligns with their values. Yet as ETF.com’s Editor-in-Chief Drew Voros points out, ESG ETFs can and often do hold names that might not be considered ESG, depending on how you define it. (Read: ESG ETFs Looking Polluted)

The largest ETFs in this space have relatively broad ESG mandates that might not meet your particular worldview. While these funds have gathered the bulk of the assets when it comes to ESG, smaller and more targeted funds might actually be a better way to achieve what ESG is meant to do. The trade-off for the higher cost of these funds is closer alignment with our ideals.

The largest ETF in this space is the $23 billion iShares ESG Aware MSCI USA ETF (ESGU). This ETF excludes tobacco companies, producers of certain weapons (but not others) and companies experiencing “severe business controversies.” Included companies are deemed to have “positive environmental, social and governance characteristics.”

Overlapping Environment

Another example is the Vanguard ESG U.S. Stock ETF (ESGV), which has gathered over $5 billion. This ETF is a little more discerning. Vanguard excludes adult entertainment, alcohol and tobacco, weapons, fossil fuels, gambling and nuclear power. The index also uses UN Global Compact principles to exclude stocks of companies that don’t meet standards for labor rights, human rights, the environment and anti-corruption.

In spite of differing negative exclusionary screens, the top 10 holdings of these two ETFs are nearly identical, with nine overlapping names.

 

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Chart courtesy of FactSet

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If these names sound familiar, it’s because most are found in the top 10 holdings of the SPDR S&P 500 ETF Trust (SPY), an ETF that has no ESG mandate.

 

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Chart courtesy of FactSet

(For a larger view, click on the image above)

 

Broad ESG mandates such as those used by ESGU and ESGV feel like they’re made to satisfy everyone—yet for discerning ESG investors, funds like these run the risk of pleasing no one.

Our values are personal, and several of the companies held within these portfolios might not meet one’s standards for what it means to be socially responsible.

Amazon Inclusion Despite Risks

The National Council on Occupational Safety and Health releases a “Dirty Dozen” list of companies on an annual basis. The list highlights companies that put workers and communities at risk. Amazon is a repeat offender, appearing as a finalist on 2019’s list as well as being included as a dishonorable mention in 2020. Sustainalytics, a top ESG data provider, also gives Amazon a “high risk” rating.

 

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Chart courtesy of Sustainalytics

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For those who prioritize workers’ rights and humane working conditions, Amazon would likely not be a suitable company for their ESG portfolio. Yet it’s included in many broad-based ESG funds since it doesn’t meet the basic exclusionary screens used by such funds.

Investors who prioritize these values could choose something like the Humankind U.S. Stock ETF (HKND). This ETF selects and weights stocks based on how much value a company creates for its investors, consumers, employees and society. Amazon has a 0.4% weighting in this fund.

 

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Chart courtesy of FactSet

(For a larger view, click on the image above)

 

Targeted ESG Options

Though these broad-based ESG funds have gathered the bulk of the assets, investors who have specific ESG values that they would like reflected in their investment portfolio would be better served by using a fund like HKND. In line with the growing popularity of thematic ETFs, issuers have launched a slew of ESG funds that are meant to align with specific values.

Is gender diversity important to you? The SPDR SSGA Gender Diversity Index ETF (SHE) invests in companies that have a high proportion of women in executive and director positions.

If racial equality is a stance you’d like to be reflected within your investments, there is the Impact Shares NAACP Minority Empowerment ETF (NACP).

For those who want their portfolio to align with their religious principles, there are funds like the Global X S&P 500 Catholic Values ETF (CATH) or the Timothy Plan International ETF (TPIF).

Pros & Cons

These funds are significantly smaller than ESGU or ESGV and have higher expense ratios, higher spreads and a higher risk of closure. But with these funds, investors know what they’re getting.

With broad mandates such as those used by ESGU or ESGV, the holdings meet some sort of ESG metric. But the investor likely has no idea why that holding is included.

Why are Apple, Microsoft and Amazon the top holdings in ESGU or ESGV? Is it for their ESG characteristics? Or is it because these companies have the highest market cap in the investable universe and the ETF is designed to have minimal tracking error to the benchmark?

 

(Use our stock finder tool to find an ETF’s allocation to a certain stock.)

 

Few companies can check all the ESG boxes. Some companies might score higher on environmental measures but do poorly in terms of governance, meaning it could meet one person’s standards for ESG while failing to meet another’s.

Targeted ETFs with explicit criteria are, in spite of their risks, a more accurate representation of what ESG investing is meant to be—a way to align your portfolio with your individual principles.

Contact Jessica Ferringer at [email protected] or follow her on Twitter

Jessica Ferringer, CFA, is a writer and analyst for etf.com. She has 10 years of experience in investment research and due diligence, including helping to manage ETF portfolios. Jessica has a bachelor’s degree in economics from Lafayette College and an MBA from the University of Pittsburgh.