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YOU MAY BE FAMILIAR with the term ESG. This is an investment approach that—in addition to traditional financial metrics—also weighs environmental, social and corporate governance considerations when picking investments.
ESG isn’t new, but it’s stirred up a fair amount of controversy recently. As an investor, it’s worth understanding what the debate is about and how you might navigate it.
ESG has been around for years, but its popularity has recently hit an inflection point. According to Deloitte, the number of investment firms offering at least one ESG fund has tripled since 2016. One new fund even carries a celebrity endorsement. NBA star Giannis Antetokounmpo has partnered with the investment firm Calamos to roll out an ESG fund. According to Calamos, the goal of the new fund will be to “generate investment and societal returns” and to “inspire, drive greatness, and contribute to a world of wellbeing and prosperity for all.”
Those are lofty claims—and Calamos isn’t alone in using that kind of language. As a result, the Securities and Exchange Commission has started taking a harder look at funds that embrace the ESG mantle. Last year, the SEC issued a risk alert for consumers. This year, it took a further step, proposing new rules to police how firms like Calamos market their funds. Under the new rules, firms would no longer be permitted to use the term ESG as freely. Instead, to aid consumers, the SEC wants fund firms to disclose in a standardized format how they’re employing ESG strategies.
With the proliferation of ESG funds, consumers, too, have been asking more questions. A common accusation is that many ESG funds are engaged in “greenwashing.” According to this argument, these funds differ only minimally from a standard market index fund—but cost much more.
Fund expert Nate Geraci, for example, recently highlighted a group of the largest ESG funds. All were much more expensive than a typical S&P 500 index fund but differed almost imperceptibly from the index. Two-thirds of them had correlations with the S&P of 95% or higher. The implication: Fund companies are taking advantage of ESG’s growing popularity to overcharge well-intentioned consumers.
ESG has also become something of a political football. On one side, progressives like Sen. Elizabeth Warren have been pressuring the SEC to impose new environmental disclosure rules on public companies. She wants to make it easier for ESG-oriented investors to vet companies before buying their shares.
Meanwhile, Florida Governor Ron DeSantis has gone in the opposite direction, instructing managers of the state’s pension fund to ignore ESG considerations and to focus only on financial criteria in choosing investments.
One fund company went even further. In a press release, the CEO of Inspire Investing declared, “We hereby renounce ESG.” With that, his company eliminated the ESG label from its entire lineup of funds. The press release went on to say that ESG had been “weaponized” by those pursuing a “harmful, social-Marxist agenda.” The language was bombastic. At the same time, though, it’s an indication of where things stand in the argument over ESG: There’s plenty of debate—but not a lot of clarity.
With all these cross-currents, how should investors proceed? I would start by asking four questions:
1. What’s your most important objective? Some investors choose ESG mutual funds as alternatives to standard index funds because they simply don’t want to be shareholders of certain types of companies. Tobacco is a common example. Personally, I hate that I indirectly profit from these companies when I invest in the S&P 500.
That’s one reason you might apply an ESG lens to your portfolio. Other investors go further, hoping to have an impact on companies by allocating their investment dollars to companies they like and away from companies they dislike.
These investors acknowledge that it’s hard for any one individual to have too much of an impact. The thinking, though, is that cumulatively investors could make a difference. Here’s how that might work: If more investors choose to buy a company’s stock, that can push up its share price. That could benefit the company in a few ways: It could issue more shares at that higher price. Or it could use its higher-priced shares to issue more stock-based compensation to employees. Either way, a higher share price is almost always a good thing for companies. On the other hand, if enough investors shun a company’s stock, that can put downward pressure on the shares and thus deprive a company of these same benefits.
Those, at least, are the textbook arguments. Because the investment universe is so large and diverse, it’s difficult to know if any ESG-driven investments have ever made, or could make, a difference. That is, in part, because it’s difficult to know the counterfactual: How much higher or lower would a company’s share price be in the absence of ESG investors?
2. What investment options exist? Perhaps the biggest challenge with ESG investing is that it means different things to different people. The acronym itself, in fact, illustrates the diversity of objectives among investors. A good example is Apple. Some ESG investors like the company because it’s very charitable. But Apple frustrates environmentalists because its products don’t have replaceable batteries. Result: It’s impossible to say whether Apple is a “good” company or a “bad” one. It’s in the eye of the beholder.
Gun makers present a similar problem. They’re generally seen as unattractive by ESG investors. But a recent article made an interesting counterargument: Weapons manufacturers also help countries—like Ukraine—to defend themselves. Because of that, perhaps ESG investors should embrace them.
The bottom line: If you’re looking to apply an ESG lens when choosing mutual funds, it’s critical to first decide on your objectives. Next, look closely at each fund to see exactly what companies it owns and how you feel about the lineup. Fortunately, there’s a great diversity of ESG funds out there. If you don’t like the way one mutual fund chooses its holdings, it’s possible that another will be a better fit.
I can’t emphasize enough that it’s important to look under the hood before choosing an investment. For example, Standard & Poor’s, in a seemingly inexplicable move, recently took Tesla—the leading maker of electric cars—out of its ESG index. That means you won’t find Tesla’s stock in funds like State Street’s S&P 500 ESG fund (symbol: EFIV). But you will find that Tesla is one of the largest holdings in the iShares ESG Aware USA Stock ETF (ESGU). That’s because iShares uses a different index.
3. Is performance a concern? To the extent that ESG-based portfolios differ from traditional market indexes, their performance will also differ. Will it be better or worse? That’s an open question. There just isn’t enough data yet to say for sure. Indeed, because there are so many different definitions of ESG, it may never be possible to generalize. But it stands to reason that their performance will almost certainly differ from traditional market benchmarks. As an ESG investor, it’s important to decide how much of a risk this represents.
4. Is complexity a concern? In general, there are three routes to building an ESG portfolio. First, you could pick individual stocks. That would give you the most control over what you own. But I don’t recommend this because of the research required to build and maintain a portfolio, and because of the risk posed by individual stocks.
The second option: You could choose a mutual fund or ETF. That’s certainly the simplest approach. But as I’ve suggested, it can be challenging to find a fund that perfectly matches your values.
Finally, you could go the route of direct indexing. This would allow you to perfectly tailor a portfolio to your own preferences, including or excluding certain industries or even specific companies. There are downsides, though. Holding a portfolio of several hundred stocks introduces complexity. Also, these services are fairly expensive relative to simple index funds, though that may be offset if direct indexing results in lower annual tax bills.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.
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For those interested in a more academic view of ESG investing, Prof. Aswath Damodaran of NYU has 3 excellent articles on ESG on his blog including one titled “The ESG Movement: The ‘Goodness’ Gravy Train Rolls On“.
Adam, a great article–thoughtful, balanced and clear. Thank you.
I appreciate the intentions of many in the ESG investing community, but as 1PF explained below, how “good” from an ESG viewpoint any company is rated, is a relative rating. And given the diversity of personal opinions and priorities, more ESG investors in a group leads to an increase in the percentage of undesirable companies. To paraphrase M Plate, my priority for investing is to maximize growth and income. So I plan to stick with investing in broad stock market indexes. How I spend and donate that accumulated wealth will be guided by my own opinions and priorities.
From my perspective, I suspect Inspire Investing’s “We hereby renounce ESG” press release statement is largely just a well-time marketing strategy rather than some ground-breaking change of investment philosophy. A few major fund families (one very large example being Blackrock) in recent years have swung the pendulum aggressively in the direction of applying ESG-like criteria as a large factor when selecting their MF portfolio holdings. More that a few shareholders are now beginning to question whether the funds they have invested in are being properly positioned to maximize shareholder value and in the most cost-efficient manner.
For a particularly vocal group of Blackrock investors, CEO Larry Fink’s fiduciary obligation (i.e. – increasing monetary value for all Blackrock shareholders) has appeared at times to take a back-seat to his assumed role as a self-appointed social conscience / environmental guardian on behalf of the millions of passive investing customers who own Blackrock shares inside of an employer-sponsored retirement plan.
When there is internal friction with one fund company, there is always going to be perceived opportunity for smaller fund companies to try and fill that void. There are thousands of mutual fund families more than happy to be the recipient of new assets should a customer opt to transfer money on philosophical grounds. Inspire Investing merely chose to hang up a big neon “Welcome” sign with their CEO’s anti-ESG press release.
Mission statement for our charitable contributions: “change the world”.
Mission statement for our investments: Be profitable.
The 2 shouldn’t be mixed
Not for me. My investments are an extension of my moral beliefs. For instance, I would never choose to work in the tobacco industry and consequently I would never want to profit from owning stock in a tobacco company. It is possible to be profitable and be good at the same time.
Thank you for this clear presentation of the issues. A couple thoughts come to mind:
I remember reading some time ago about how even the “good” ESG companies invariably rely on some resources that are bad for the environment. No company could be found to be 100% “good” by any criterion.
Differences in criteria for whether or which companies “should” be removed from an index echo, to me at least, the controversy about banning books in schools. If I had children in school, I’d actually look forward to discussing those books with them. As for ESG, I’ll stick with broad-market index mutual funds and then direct my charitable contributions to where I think they’ll do the most good.