By Debbie Carlson
Sustainable investing is hot, and when Wall Street sees a trend, it wants a piece of the action.
How hot? In 2020, US SIF Foundation, which measures this type of investing, said 33% of U.S. assets under professional management use environmental, social and governance criteria when investing. That’s $17 trillion, or one in three U.S. investing dollars.
No wonder fund issuers are furiously trying to capture those dollars. Morningstar said in July that 25 funds with sustainable mandates launched in the U.S. in the second quarter of 2021, the second-highest number ever issued. As of June 30, there were 437 open-end mutual funds and exchange-traded funds dedicated to this investing style, according to the research firm.
How do you know if your fund is really an ESG fund or just a green marketing ploy? Roll up your sleeves, as more than any other investment style, ESG requires you to know what you want, what you’re willing to pay and what the fund will deliver.
ESG investing adds a layer of squishiness to traditional financial analysis because the heart of it is investing according to your values, and everyone’s values are different. What’s greenwashing to me might be fine for you. It’s much more nuanced than buying a low-fee fund that tracks the S&P 500 index /zigman2/quotes/210599714/realtime SPX -0.84% .
Here are eight questions to ask yourself so you can decide whether an ESG fund is legit or is just greenwashing.
1. What values are important to you?
Know thyself first. Some investors want to focus on one pillar of ESG, such as the environment. Others want a fund where there’s a broad consideration of all three. Ranking the E, S, and G matters because funds may hold companies you don’t like, and no company is perfect. For example, if you want a clean-tech company that has strong product safety measures and treats workers well, then Tesla /zigman2/quotes/203558040/composite TSLA -6.42% may be a dealbreaker, and you have to decide whether you can nonetheless accept it in a fund.
Consider the type of investor you are to figure out what kind of investment you are looking for – a broad market fund that avoids fossil fuels completely or a narrow niche fund betting on the sometimes-risky companies that might benefit from an energy transition? There’s a lot to consider.
2. Can I own a cheap index fund and still be ESG?
It depends on what you want. Sector-neutral ESG index funds try to mimic the broader market to deliver market-like returns while holding those stocks that they believe have the highest total ESG score. The word “total” is doing the heavy lifting here.
The fund company lays out the criteria and methodology, and the index provider selects the holdings using third-party ESG scoring metrics from firms like MSCI or Sustainalytics.
These sector-neutral funds will own companies in “dirty” sectors such as energy or industrials, such as Exxon Mobil /zigman2/quotes/204455864/composite XOM -0.64% . For some ESG skeptics, this greenwashing at worst, a marketing ploy at best.
Others disagree. Todd Rosenbluth, director of ETF and mutual fund research at CFRA Research, says sector-neutral ESG ETFs may own polluting energy companies because the firms’ scores on social (such as paying workers well) or corporate governance (like a diverse board) may be strong enough to offset a weak environmental score.
Go beyond the holdings and dig into the prospectus to understand the fund’s methodology. Does it screen out certain companies, such as those that make alcohol, weapons or tobacco? Does it include certain types of companies and how do they measure sustainability? The fund should explain how it sets the criteria behind the methodology. From there you can decide if the fund is greenwashing or represents the best in every sector.
“ESG covers a lot of ground and its easy to end up with something that is not as narrowly focused on what matters to you as an investor and thus looks as if you’re getting a greenwashed product that isn’t as ESG-oriented as you want it to be. The wonderful thing about ETFs is that you can look inside the portfolio before buying it,” Rosenbluth says.
3. Are you willing to pay managers to advocate for sustainability?
A criticism of index ESG funds, especially the sector-neutral funds, is they are “ light-touch ” funds because they’re simply a list of high-scoring ESG companies; the portfolio managers don’t do anything with that data, such as engage in shareholder advocacy and may not vote at shareholder meetings with ESG in mind. That makes them cheap, perhaps costing 0.10% annually to own, or not much more than the lowest-cost index funds.
Traditionally, sustainable investing centered on actively managed mutual funds where portfolio managers selected companies and engaged with boards to make their operations more sustainable and a higher-quality company, hopefully improving the bottom line over time. That work doesn’t come cheap. An actively managed mutual fund may cost at least 0.50% annually, and oftentimes more.