ESG ETFs Are Not About ESG Investing

Summary

• We remain sceptical that ESG-oriented investing – especially through ETFs – is an effective way to achieve ESG goals or investment outperformance. Many ESG funds hold companies an investor may disapprove of, and any ESG fund outperformance will likely be due to non-ESG factors.
• A sample of broad ESG ETFs outperformed SPY both since inception and the US election. We attribute this to avoiding troubled sectors and companies rather than ESG criteria per se.
• Specialised ESG ETF performance varies widely, but this appears more due to idiosyncratic factors than ESG criteria.
• ESG ETFs are generally tiny, suggesting the ESG concept is hardly enthralling investors – at least at the ETF level.

Market Implications

• We recommend investors interested in investing based on ESG criteria focus on individual companies rather than ETFs.

Back in May we asked, does an investment strategy based on environmental, social, and governance (ESG) principles make sense from an investment standpoint? For reasons summarized below, we concluded it conferred little or no advantage. In this note, we examine how a selection of ESG-oriented ETFs have performed versus SPY – the ETF that tracks the S&P 500.

The Manifold Problems With ESG

What Performance? For all the hype about ESG investing, and the effort of many companies to appear ESG compliant, there is little hard academic evidence that following an ESG-oriented investment strategy produces superior investment returns or is a distinct investment factor (like value, small company or momentum, to name a few).

Measurement Blues. According to the Global Initiative for Sustainability Ratings, an organization that reviews and accredits ESG vendors, over 100 vendors and agencies provide some form of ESG rating. Major vendors with a decade or more in the ESG rating business include MSCI, Sustainalytics, Thomson Reuters, and RepRisk. More recently, Bloomberg and Standard & Poor’s Global started publishing proprietary versions of ESG ratings, and Moody’s now incorporates ESG criteria into its company and sovereign credit rating methodologies.

Each vendor has its own method for evaluating and scoring ESG. Consequently, scores vary across vendors, putting the onus on investors to determine which one or ones meet their needs.

A primary source for ESG vendors is information the company provides through publicly available documents (e.g., financial reports, press releases, and regulatory filings) and, in some cases, surveys conducted by the vendor. Some vendors supplement this with information gleaned from articles in the press or comments and blogs on the internet.

The International Accounting Standards Board has started to coordinate the efforts of several standard setters to create a consistent framework for reporting ESG compliance.^[1] Financial regulators in the US and Europe are also considering additional disclosures related to climate and sustainability. What they come up with remains to be seen.

The bottom line is, ESG means different things to different people.

Greenwashing Is Not Cleansing. Another problem with the environmental leg of ESG is greenwashing. It is all too easy for a company to burnish its ESG stats by selling off a dirty business or factory or outsourcing dirty production abroad – but this does little or nothing to cut global emissions.

So How Do ESG ETFs Perform?

A wide range of ESG-oriented EFTs exists – upwards of 250 by one count. Most are tiny, focusing on narrow niches. For our purposes, we look at 10 ETFs; five are broad market ETFs, and five target specific ESG goals (Table 1).

Broad ETFs Are Not About ESG. The five broad ETFs track broad market indices such as the ESG Aware MSCI USA Index, which seeks to maximize exposure to companies with favourable ESG characteristics. These ETFs generally exclude various companies that may be controversial or subject to significant business risk, and companies with significant exposure to alcohol, tobacco, gambling, nuclear power, conventional and nuclear weapons, and civilian firearms. Otherwise, they generally hold companies in their target indices, although they each have slightly different criteria for selecting large- and mid-cap companies, and weighting different aspects of ESG scores.

All five broad ESG ETFs have outperformed SPY both since inception and the US election. The since-inception performance partly depends on the vagaries of when the fund was launched. ESGU and ESGV, for example, are similar in structure but show annualized returns of 0.77% and 1.82%, respectively. Their performance since the election have been virtually identical. The two ETFs that have been outstanding since the mid-2000s and experienced multiple major market cycles (DSI and SUSA) have the lowest annualized returns.

All have performed well since the election – hardly surprising given the Biden administration’s largely ESG-friendly policy thrust, especially on environmental issues. But much of the outperformance was during the first few months; since February, these ETFs have traded in narrow ranges, as exemplified by ESGU (Chart 1).

We also note the following:

• All these funds are more about avoiding certain types of companies than targeting companies with high ESG ratings. For the record, ESG scores focus on how a company produces its products and services – not whether it produces sin products such as alcohol, gambling or weapons.
• One potential issue for investors interested in environmental issues is the general exclusion of nuclear – some believe it is the best way to ensure a carbon-free energy supply.
• These funds are small. Even the largest (ESGU) is only 5.6% of SPY; the others are around 1% or less of SPY. Clearly, they have not been a big draw for investors.
• Given their stated investment criteria, it is unsurprising that any outperformance has come from factors other than ESG criteria.

The bottom line is that to the extent these ETFs attract performance-oriented investors, it will be for reasons other than their ESG credentials.

Specialized ESG Funds Vary. Then there are ETFs that target specific ESG strategies. We selected a few that focus on religious, gender and racial criteria. Their performance since inception and election varies widely, both out- and under-performing SPY. We have not delved into the specific holdings of each, but we note two – CATH and TPIF – target Catholic and Christian values respectively and would be expected to be broadly similar in structure. But CATH has outperformed handily, and TPIF has underperformed badly. The differentiating factor is that TPIF is the only ETF in our sample that invests internationally; the others are US-focused. Clearly, relative performance here has little to do with ESG criteria.

All these funds are also very small, with assets less than $1 billion. Again, this is hardly an endorsement of an ESG-oriented investment strategy.

The Way Forward…

Investors interested in ESG-oriented ETFS – whether broad or narrow – must do a fair amount of homework. They should determine whether the investment criteria and mix of companies meet their goals and whether any potential out- or under-performance will be due to ESG or other factors.

On balance, we suggest investors focused on ESG criteria would do better investing in individual companies rather than ESG-oriented ETFs.

1. These include the Value Reporting Foundations (formed through a merger of Sustainability Accounting Standards Board and International Integrated Reporting Council), Climate Disclosure Standards Board, Global Reporting Initiative. In addition, financial regulators in the US and Europe are considering requiring climate related disclosures. ↑