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For Goodness Sake

Richard Connor  |  November 20, 2020

AS YOU STRIVE to do well, should you also strive to do good?

We’re seeing a boom in environmental, social and governance (ESG) investing. For instance, according to a recent Morningstar report, there are now 534 index mutual funds and exchange-traded funds (ETFs) around the world that screen their holdings using ESG criteria. Together, these funds have almost $250 billion in assets—more than twice the sum they had three years earlier.

ESG investing offers a way to invest in funds that consider issues such as the use of natural resources, community impact and gender diversity on corporate boards. Intrigued? Fidelity Investments has six ESG stock and bond mutual funds. Meanwhile, Vanguard Group has two ESG stock mutual funds and two ESG stock ETFs, plus its recently launched ESG U.S. Corporate Bond ETF.

Funds incorporate ESG strategies in a variety of ways. Some integrate ESG factors with traditional investment analysis. Others perform portfolio screening, looking either to exclude (like cigarettes) or include (like green energy) specific sectors or companies. They might also consider investments based on a company’s advocacy, such as its charitable endeavors. Finally, ESG funds could focus on impact investing, by targeting investments with an eye to having a positive societal or environmental impact. All these strategies are supposed to provide a competitive financial return.

Consider Vanguard’s FTSE Social Index Fund Admiral Shares (VFTAX). It currently tracks the performance of the FTSE4Good U.S. Select Index. That index excludes stocks of certain companies in the following industries: adult entertainment, alcohol, tobacco, weapons, fossil fuels, gambling and nuclear power. The index also excludes stocks of certain companies that don’t meet the standards of the U.N. Global Compact principles and companies that don’t meet certain diversity criteria. The fund has a 0.14% annual expense ratio, equal to 14 cents a year for every $100 invested.

The Admiral version of the Vanguard fund is fairly new, so it’s hard to judge its performance. But we can look at the returns of the index and at how well the fund matches that index. The FTSE index, coupled with an earlier index tracked by the Vanguard fund, has a 10-year annualized return of 14.3%. By comparison, the S&P 500 has a 13% return over the same period. The Vanguard fund’s Admiral Shares have only been around since February 2019. During that time, the index has returned 17.09%, while the fund has returned 16.95%.

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I compared the Vanguard fund’s holdings to the S&P 500’s holdings. The Vanguard fund has 471 positions. Of the top 50 holdings in the S&P 500, 44 are in the Vanguard fund. The first six holdings are identical. Surprisingly, Berkshire Hathaway, No. 7 in the S&P 500 by market capitalization, is not one of the Vanguard fund’s holdings. Also absent from the Vanguard fund are the oil giants and the big defense contractors. A casual comparison gives the impression that the Vanguard fund is simply the S&P 500 with some notable companies subtracted. That said, you will find that Tesla—not currently in the S&P 500, but soon to join the index—ranked as the Vanguard fund’s ninth largest holding as of Sept. 30.

ESG funds are not without controversy. Famed investment author Burton Malkiel recently wrote about ESG investing in The Wall Street Journal. Malkiel noted that the various agencies that rate companies on ESG criteria often disagree. Moreover, he says their ratings “tend to be divorced from considerations of how environmental, social and governance performance can influence future financial results.”

Malkiel gives the example of Xcel Energy. The company currently has one of the biggest carbon footprints in the electric utility industry. This is because Xcel generates a large share of its power from coal. But as Malkiel explains, Xcel is also the first U.S. utility committed to going 100% carbon-free by 2050 and it’s a leader in building wind-generation facilities.

Many ESG funds would exclude Xcel due to its carbon emissions. But others may look at its investment in green energy and choose to invest based on the company’s potential impact and future profitability.

The upshot: Investors can’t always be sure their ESG funds are having the desired impact. On top of that, despite strong recent returns, there’s no guarantee that future performance will keep up with the broad indices. As ESG investors shun unlovable companies and thereby help to depress their share prices, they could potentially set those stocks up for higher future returns—and those returns would be earned by investors who ignore ESG criteria.

Richard Connor is a semi-retired aerospace engineer with a keen interest in finance. Rick enjoys a wide variety of other interests, including chasing grandkids, space, sports, travel, winemaking and reading. His previous articles include That Monthly CheckMargin of Safety and State of Taxation. Follow Rick on Twitter @RConnor609.

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