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.