ESG funds: Does what's inside count?
25 Oct 2021- Stephen Bosch
10 min read
I have been very pleased with the performance of my index ETFs. I tell myself it’s because of their low cost and the fact that they’re passive. But I’d like to make my portfolio more sustainable, more future-proof. So I’ve been looking at the ESG-labelled exchange-traded funds of some of the biggest fund managers, and I’ve noticed something about nearly all the funds I look at.
- ESG funds are not much different from regular funds.
- Too much money is chasing too few investment opportunities.
- ESG isn’t really ESG. Util evaluated 75 sustainable funds and found just five that scored positively on all five environmental SDGs. Currently, adhering to the strictest ESG criteria will result in a portfolio that sacrifices diversification and increases portfolio risk.
- A look at the Domini Sustainable Solutions Fund.
- Expense ratios and fees
- You can have some notion of sustainability, diversification, and risk-adjusted performance. Pick two.
- Retail investing is harmful because it overwhelmingly funds business activity that remains unsustainable. This is a systemic problem.
ESG funds are barely distinguishable from total market funds.
Here are the top ten holdings in Vanguard Canada’s VXC FTSE Global All Cap ex Canada Index ETF (ISIN: CA92206Q1019) (as at 30 September 2021):
|Holding Name||% of Market Value|
|4||Facebook Inc. Class A||1.10595|
|5||Alphabet Inc. Class A||1.10003|
|6||Alphabet Inc. Class C||0.99191|
|9||JPMorgan Chase & Co.||0.66865|
|10||Berkshire Hathaway Inc. Class B||0.65844|
This is a total market fund without any ESG investing criteria.
Here are the top ten holdings in BlackRock’s iShares MSCI World ESG Screened UCITS ETF (Ticker SNAW, ISIN IE00BFNM3J75) (as at 22 October 2021):
|3||AMAZON COM INC||2.61|
|4||ALPHABET INC CLASS A||1.43|
|5||ALPHABET INC CLASS C||1.39|
|6||FACEBOOK CLASS A INC||1.34|
|9||JPMORGAN CHASE & CO||0.90|
|10||JOHNSON & JOHNSON||0.74|
And here are the top ten holdings in DWS xtrackers MSCI World ESG UCITS ETF 1C (Ticker XZW0, ISIN IE00BZ02LR44) (as at 16 September 2021):
What do you notice?
The first thing I noticed is how similar they seem.
Granted, two of the above funds ostensibly follow the same index (MSCI World), but each have ESG “screens” whose purpose and function do indeed seem about as opaque as a real screen:
- For SNAW, it’s the MSCI World ESG Screened Index.
- For XZW0, it’s the MSCI World Low Carbon SRI Leaders Index.
We can guess why Facebook is missing from one, but then why is it in the other? Presumably MSCI publishes information about its screens. But this will not be obvious to the typical retail investor. (It certainly isn’t obvious to me.)
The second thing is that the top ten holdings of all these funds include Microsoft (software and services), Alphabet (Google’s parent company, and twice!), Tesla (electric vehicles) and NVIDIA (computer graphics hardware).1
The major index funds are increasingly tech heavy. This is in part because these indices are weighted by market capital, and tech stocks have enjoyed multiple years of strong growth. But the ESG funds are even more heavily weighted towards these stocks.
There is too much money for clean economy stocks to usefully absorb
We have institutional investors under pressure from their stakeholders to green up their portfolios, and yet there just isn’t enough stable, green business to go around yet.
But the money keeps flowing and it has to go somewhere, so fund issuers are bending their sustainability criteria.
From the 11 October 2021 edition of Tim Quinson’s Good Business newsletter (Bloomberg):
After soaring 142% in 2020, the S&P Global Clean Energy Index has dropped 23% this year. Despite the market swings, the money keeps pouring in. BlackRock’s iShares Global Clean Energy, the largest exchange-traded fund in this space, has attracted more than a net $2.8 billion since the start of 2021—even as the ETF posted investment losses.
The iShares fund tracks the S&P Global Clean Energy Index, and its giant inflows helped lead to an overhaul of the market benchmark. There were 30 stocks in the S&P Global Clean Energy Index until it was revamped in April because too much money was chasing too few stocks. Now, there are 81, and the number may rise to as many as 100.
While the new additions have bolstered the index’s diversity and liquidity, they’ve also resulted in the inclusion of companies that aren’t the cleanest of energy producers. Before the adjustments, the S&P Global Clean Energy Index had the purest “clean energy exposure score” of 1. Today, the average-weighted score is closer to 0.85.
It is safe to say that if you buy an ESG fund today, you are not getting what you think you are getting. Right now, ESG is just a nice story. Nice stories are just nice stories, right? Not if they are hiding risks from you.
The optimistic view of this is that we are just at the very beginning of a massive transformation of the economy, and the investment pressure will drive change in the medium and long term. That may be true, and I would like to believe that it is.
But as the basis for investment decision-making today, it is inadequate. This is hugely uncertain and very risky.
No amount of desire and good intentions is going to conjure up stable, sustainable going concerns. We just don’t have these yet.
Even ESG isn’t really ESG
A analysis conducted by the London-based company Util found that, of the 75 “sustainable” funds it evaluated, at most five scored positively on all five of UN’s environmental Sustainable Development Goals.
- “On an absolute basis, there’s little difference between sustainable and vanilla funds. The net SDG score of the sustainable funds is 3/100, versus 1/100 for the total fund universe. That’s a mere 2 percentage-point difference (for which investors are paying an average 43% higher fee).”
- “SDGs fit into three-to-five categories: people, planet, and prosperity (including partnerships and peace)—or, broadly, social, environmental and global economic progress. Both the total and sustainable fund groups follow a consistent pattern: positive impact on prosperity SDGs, slight-positive impact on social SDGs, and negative impact on environmental SDGs.”
- “Where sustainable funds are perceived to be overweight tech, underweight oil & gas, an average fund is thought to be more evenly balanced. It’s not. The fund groups are similarly exposed to software (18% vs. 16%) and oil & gas (1% vs. 2%). Broadly, the groups are aligned.”
If anything, adhering to the strictest ESG criteria will result in a portfolio that sacrifices diversification, thus increasing portfolio risk.
What does a “truly sustainable” fund look like?
Let’s assume for a moment that such a thing exists. Of the five funds that scored positively on all of the UN’s environmental SDGs, the top fund was the Domini Sustainable Solutions Fund (Ticker CAREX, ISIN US2571327616).
Let’s examine this fund against my basic criteria:
The fund invests across sectors, in particular information technology, health care, industrials, consumer discretionary, financials, communications services, consumer staples and real estate. That is good. But again, it’s technology heavy (31.0% of the portfolio), and it contains just 37 stocks:
|Security Name||% MV|
|1||ENPHASE ENERGY INC||5.14%|
|2||AMERESCO INC CL A||4.40%|
|5||SQUARE INC A||3.89%|
|9||PALO ALTO NETWORKS INC||3.35%|
|10||ZOOM VIDEO COMMUNICATIONS A||3.28%|
|11||TELADOC HEALTH INC||3.26%|
|14||KURITA WATER INDUSTRIES LTD||2.94%|
|15||NEW YORK TIMES CO A||2.94%|
|16||ASML HOLDING NV NY REG SHS||2.90%|
|17||MUENCHENER RUECKVER AG REG||2.73%|
|19||SAMHALLSBYGGNADSBOLAGET I NO||2.62%|
|20||FEDERAL AGRIC MTG CORP CL C||2.61%|
|21||INSPIRE MEDICAL SYSTEMS INC||2.61%|
|22||VESTAS WIND SYSTEMS A/S||2.57%|
|27||EXACT SCIENCES CORP||1.93%|
|28||UNIVERSAL DISPLAY CORP||1.89%|
|30||ULTRA CLEAN HOLDINGS INC||1.83%|
|32||ALFEN BEHEER B.V.||1.73%|
|33||BEYOND MEAT INC||1.70%|
|34||BASIC FIT NV||1.70%|
|37||AMALGAMATED FINANCIAL CORP||1.01%|
Active vs. passive management
This is decidedly not a passive index fund.
As an active fund, I expected this fund to be more expensive than your classic Vanguard index fund.
But this fund has an annual expense ratio of 3.95%.
That means that if your underlying return is, say, 10%, your take-home will be marginally above 6%. And if your return is flat (0%), your take home will be… -3.95%.
Domini shows two annual expense ratios, one a “gross” (the aforementioned 3.95%) and the other a “net” expense ratio, which is currently 1.40%. Fund managers everywhere are under growing pressure to control fees, and this appears to be a response to that pressure. This is typically done with something called “fee waivers and reimbursements”, which are essentially rebates not unlike those you might get when you buy something in a store and then get money back from the vendor or manufacturer later. But in every case it is understood that you are paying up front and getting some of that money back, and the prospectus for CAREX contains the following caveat:
The Fund’s adviser has contractually agreed to waive certain fees and/or reimburse certain ordinary operating expenses in order to limit Investor and Institutional share expenses to 1.40% and 1.15%, respectively. These expense limitations are in effect through November 30, 2021. There can be no assurance that the Adviser will extend the expense limitations beyond such time. While in effect, the arrangement may be terminated for a class only by agreement of the Adviser and the Fund’s Board of Trustees.
Why the asterisk? Repeat after me: past performance is no guarantee of future results.
Still, it’s worth looking at here to calibrate expectations.
To my surprise, CAREX has, over its lifetime, outperformed the S&P 500:3
A couple of things to note about this fund:
- It is not that old. It was created 1 April 2020. This happens to be near the bottom of the market flash-crash caused by the coronavirus pandemic. We can expect the fund’s performance to regress towards that of the total market (regression to the mean) as more time passes.
- It does not have many assets under management (37.6 million USD as at 30 September 2021). That doesn’t have to be a bad thing, as small funds can choose from a broader palette of different securities, including small-cap securities that offer better returns.4 But small asset bases mean higher fees for everybody. The fee waivers are an indicator that the fund manager is banking on the fund growing. If it does not, the fee waiver may be cancelled.
- The large swings in the fund’s value could have any number of causes. I have not looked at changes in the fund’s composition since inception.
You can’t have it all
You can have some notion of sustainability, diversification, and risk-adjusted performance. Pick two.
So what does this all mean for you?
As an investor, I am profiting from a system that is harming the planet. It doesn’t matter how much I want things to be different or how much money I throw at companies claiming to offer solutions, the simple fact is that right now, it’s the system that is causing the harm and, by extension, anything within it.
I am not saying it’s not worth applying socially responsible investing criteria to your investments.
What I am saying is that it needs to be with an understanding of what you are giving up and the accompanying risks in the process.
We are many years away from a regime in which measures for the sustainability and social responsibility of business and industry are objectively comparable, transparently available and comprehensible to the retail investor.
Right now, it’s better to think of investments in clean technologies as risk plays, a bet on a new, zero-carbon, circular economy future. But as with any venture, even in an exciting, new and growing market, any given investment can fail. You can be in the right sector, in the right industry, at the right time, and still pick the company that fails. With everything changing so rapidly and with so much uncertainty, it’s impossible to have any confidence what the right bets are.
So stay critical. Don’t believe everything people tell you. And keep hunting. ⊡
(DISCLAIMER: I am not a financial advisor. This is not financial advice.)
NVIDIA makes video processors (graphics processing units, or GPUs) for gaming consoles and computers! Why would it be in the top ten companies with the largest market capitalization? Well, GPUs are very good at one thing: parallel processing. And what applications need lots of parallel processing? Supercomputing… and cryptography. If you noticed that cryptography contains the word stem crypto, I award you a virtual ribbon! It would indeed be interesting to see how NVIDIA’s market performance tracks the price of Bitcoin, a cryptocurrency that uses proof-of-work and is now consuming huge amounts of computing effort around the world. ↩
I am aware that this is company PR for Util. But it is calling out the industry for misleading the public, and that is worth noting. ↩
I am using the SPDR S&P 500 ETF Trust (Ticker SPY, ISIN US78462F1030) as a proxy for the S&P 500. ↩
Always in exchange for more risk! There is no such thing as a free lunch! ↩