Why ESG Exchange-Traded Funds might not be as green as you think

If you’ve dabbled in the stock market, you’re probably familiar with Exchange-Traded Funds (ETFs). These are investment vehicles that track an underlying index, sector, commodities etc. Instead of investing in just one company, you diversify your holdings and hold a basket of shares that trade for a market price. This type of investment has boomed in popularity. Passive investment, either via ETFs or index funds, accounts for almost half of the total investment market. These funds are also the asset of choice for retail investors, given the low fees and high liquidity.

ETFs can also be built to match specific goals. In fact, Environmental, Social and Governance (ESG) ETFs, or thematic ETFs, such as those aligned with specific goals like the United Nations’ Sustainable Development Goals or women-owned businesses, have recorded a 223% growth rate over 2020.

There are several factors driving this market shift. For one, millennial investors have entered financial markets in big numbers and care a lot about sustainable investing. Other reasons include a general emotional preference for ESG investing, as well as ever-improving ESG datasets.

But as retail investors pile into ESG-aligned ETFs, a big question arises: How green really are these investments? The short answer is it depends.

Why it’s hard to ‘look under the hood’ of an ESG ETF?

Sustainable investing is complex. As it has evolved, so too has the glossy advertising terminology (sustainable ETF, Green ETF, etc.). However, none of these labels are overseen by the regulators. This lack of consistency creates widespread concerns that the industry is misrepresenting how an ETF incorporates ESG factors.

Some market participants (like Tariq Fancy, former Chief Investment Officer for Sustainable Investing at Blackrock) have said there have been many instances where funds were rebranded as “green” with no discernible change to the fund or strategies. This is called greenwashing and such accusations are gaining prominence. In fact, over 80% of ESG ETFs today have some exposure to fossil fuel users and producers – a quirk in the way the indices are compiled.

What really makes ‘looking under the hood’ so tricky is that the funds are not required to publish 100% of their holdings. There is also a lot of variation in how the ETFs are built – some funds might exclude certain industries (such as tobacco or weapons), while others might prioritize higher-rated ESG companies. This strategy is not always made clear to an average retail investor.

But does ESG investing even pay off?

Well, it can. ESG provides a framework for firms to consider 21^st century business risks and opportunities (meaning, in theory, improved investment returns). The logic goes that investing in businesses with better ESG ratings will lead to outperformance. Research from data provider Morningstar, using a sample of 745 Europe-based sustainable funds in 2020, found that the majority have done better than non-sustainable funds. And, ESG funds were also found to be more resilient in the tumultuous year that was 2020.

However, don’t hit purchase on that ESG ETF just yet. A recent academic study found that as more and more specialized ETFs have hit the market, products were delivering lower and lower returns but at higher costs.

So, what can the average investor do to fact-check an ESG ETF?

The short answer is: Be proactive in doing your homework.

1. Read the fund documents – for real this time!

We have all heard the disclaimer “Read the fund documents carefully before investing.” Yet, very few of us give the information the reading time it deserves. This is even more important for sustainable investing.

Where to start? Focus on a few key pieces of information such as the holdings of the ETF, the fees and the credentials of the manager. Not all providers share a complete list of holdings (this isn’t legally required in all countries). But they will list the Top Five – 10 holdings in the factsheet. If the holdings appear to be the same as the non-ESG alternative, check the difference in fees and make your decision.

Another important piece of information could be the credentials of the fund manager. Do they have any experience managing ESG ETFs or do they have an ESG certification, perhaps? Between LinkedIn and the asset manager’s website, you will definitely find some information.

2. Check whether an existing fund strategy was rebranded as ESG

As fund managers have recognized the importance of the ESG branding, many have rebranded and relaunched existing ETFs to switch to an ESG strategy and added terms such as “sustainable” to their fund titles.

While it is possible that the fund plans to fully integrate ESG into its processes after rebranding, there are many cases where there is no discernable change to the fund or the underlying holdings. Therefore, approach recently rebranded funds with caution. A simple google search with the ETF name and the key word “rebrand” should provide you all the information you need.

3. Consider being more active and engaged

Every shareholder has a vote, but very few use them. Low retail voter turnout is the norm. If you want to have a voice on ESG issues that are important to you, then don’t ignore your ballots. Take a closer look at the diversity and inclusion policy, board nominees, etc. If your current financial advisor or fund manager doesn’t provide information about proxy voting, ask for it. While the onus should not be on retail investors to ask for such information, this might be the only option for now.

Another option is to engage with nonprofit organizations such as Follow This. You can buy shares in large oil and gas companies and let the organization raise and push environmentally conscious resolutions on your behalf while you retain full ownership of your shares. You might have heard about its recent big win against Chevron, to reduce emissions from the company’s customers.

You may be only one investor, but you have the tools to evaluate, compare and decide which ETF aligns with your own values. An informed and well-researched investor is a step closer to moving the market in a sustainable and responsible direction.