Wall Street is trying to bottle ESG, but ESG has other ideas.
Mutual funds and exchange-traded funds based on environmental, social and governance attributes have gathered a lot of money recently. They took in $51 billion in 2020, $3 billion more than during the previous 11 years combined, according to Morningstar. This year’s flows are even bigger, $56 billion through September.
For fund companies, it’s a sure sign that demand for ESG is surging, and they’re rushing to meet it. They launched a record 90 ESG funds in 2020 and kept it up this year, starting 110 through September. Many more are planned or on the way. They’re also getting help from index providers, who are rolling out ESG versions of popular indexes. Want an ESG-friendly S&P 500? There’s an index for that and at least two ETFs that track it.
At its core, ESG is just a variation on a game that fund managers have played for decades: Pick stocks and bonds and charge a hefty fee for it. The basic premise is that investors can make more money investing in companies with ESG attributes that make them less risky or more likely to deliver higher returns or both. These companies might have lower carbon emissions (E) or higher customer satisfaction and labor standards (S) or independent and diverse boards of directors (G). Many ESG attributes, or factors in ESG-speak, are quantitative, so they can also be tracked by an index.
In that regard, ESG is no different from picking companies based on expected growth, valuation, yield or any one of many financial criteria fund managers have long used to find the best companies. But ESG is straying from its roots as a well-defined investment strategy, and that’s a problem for fund companies.
Traditional styles of investing such as growth and value have become simpler, more transparent and easier to understand over time. So simple, in fact, that most traditional styles are now easily replicated by indexes. ESG, on the other hand, is becoming murkier, harder to define and explain, if it can still be called an investment strategy at all. That makes ESG increasingly difficult, if not impossible, to deliver in a fund.
One challenge is that ESG factors are proliferating, in many cases with scant evidence that they have a reliable impact on companies’ performance. There’s also growing disagreement about how to measure ESG factors. Ratings firms offer guidance, but each has its own methodology and related ESG scores. The arguments about which ESG factors are legitimate and how to gauge them mean there’s little consensus about how to approach ESG. Some fund companies now offer multiple ESG funds, each with its own take on the strategy, leaving investors to navigate a growing minefield of ESG approaches.
Even more problematic for fund companies is that ESG may no longer be interested in making money. Investors increasingly view it as a way to align their portfolio with their values, regardless of the financial impact. But values are personal, and no one fund can accommodate all or even most of them, which necessarily limits the appeal of ESG funds.
That hasn’t stopped some funds from trying. BlackRock’s recently launched iShares ESG Advanced Investment Grade Corporate Bond ETF, for instance, excludes 14 offending industries, including common exclusions such as fossil fuels and weapons, and more niche ones like palm oil. But how many investors have a beef with the same 14 industries?
Direct indexing
More likely, if portfolios are expressions of individual values, then every investor needs a custom portfolio. And that may be where ESG is headed. So-called
Still, fund companies have every reason to hope ESG funds can appeal to investors. They face increasing pressure to lower fees, and they’re banking on ESG funds to command a premium. The average expense ratio is 0.93% for ESG mutual funds and 0.58% for ESG ETFs, in both cases many times the cost of a broad market index fund. They may even get help from groups that are working on ESG standards and promoting greater ESG disclosure from companies, such as the Sustainability Accounting Standards Board, which could rebuild consensus around ESG and make it easier to sell funds.
One ESG fund isn’t waiting around. Engine No. 1 Transform 500 ETF sells its approach to ESG as an unapologetic attempt to make money. The fund is “purpose-built to create long-term value” by owning companies that invest in their employees, customers, communities and the environment, according to the fund’s website. It also charges just 0.05%, which is in line with the cost of an S&P 500 index fund. That may be a winning combination. Roughly 250 ETFs have launched since Engine No. 1 debuted in June, and its $257 million in assets puts it among the 10 largest of those funds.
I’m not an ESG skeptic. I can easily imagine a day when the evidence is clear that companies that pay attention to environmental risks, treat their workers and customers with dignity and put guardrails around executives and directors also perform better and make more money for shareholders. But ESG is drifting from that premise, which makes the case for ESG funds harder to grasp, too.
