Can you afford to be a responsible investor?
That’s the question that has plagued pensions and individual investors alike as they consider financial products dedicated to environmental, social and governance criteria. In two recent polls, a majority of institutions and high-net-worth investors concluded fees were too high to justify an allocation.
Conventional wisdom has been investors would be willing to pay more (or sacrifice returns) for investment funds that boast a double bottom line — that is, any fund that has both a financial and an ESG/responsible investing goal. However, fee pressure is now in full effect, even among the do-good set. Where it once wasn’t uncommon to see fees as high as 1.25% (and front-end sales charges, or loads) in responsible investing funds, newer fund launches have come with markedly lower expense ratios.
Just this month, Vanguard, arguably the czar of low-fee fund offerings, jumped into the ESG fray with the Vanguard ESG US Stock ETF
and the Vanguard ESG International Stock ETF
offerings. The funds will track the holdings of the FTSE US All Cap Choice and FTSE Global All Cap ex US Choice indexes — two ESG indexes — and fees are slated at 0.12% and 0.15%, respectively. The funds will incorporate elements some elements from more traditional Socially Responsible Investing (“SRI”) by excluding certain “sin stocks” such as those in adult entertainment, alcohol, tobacco, and weapons, and the funds will also exclude fossil-fuel firms from its investment portfolios. From there, the funds will apply an ESG overlay to the stock portfolios. The fund will also attempt to maximize the United Nations Sustainable Development Goals in its investment decisions.
Vanguard estimates the fees for the U.S. fund are 87% lower than funds with similar holdings and estimates the international fund’s fees are 85% lower than similar funds.
But the real question for investors is whether a low-fee, passive approach to ESG will achieve optimal returns.
Passive funds and index offerings are usually reliant on data, generally consisting of index constituents or a quantitative determination of investment “winners.” ESG data is by its very nature nonfinancial data, which can make it pretty hard to quantify. Scores for ESG can therefore vary widely between firms and data providers, depending on the factors they incorporate into their final ESG tally.
A few studies have underscored the difficulty in using ESG rating data alone to screen investments. The Wall Street Journal recently highlighted some of these issues by pointing to provider discrepancies between ratings on Telsa
For example, ESG data provider MSCI ranks Telsa as a top ESG choice, while FTSE ranks it the lowest among auto makers based on ESG factors. One reason for the divergence is that the MSCI rating takes into account the environmentally-friendly product Telsa delivers, while FTSE considers not Tesla’s low-carbon cars but instead the Source 1 emissions generated by manufacturing operations.
Whether a ratings firm considers all ESG information equally or only disclosed information can also result in the same company receiving wildly different ESG ratings from competing providers.
Portfolio construction can be a bit of a bear for passive ESG funds, too. Perhaps not surprisingly, some sectors may naturally have companies with lower ESG scores (energy, materials) while others may tend to score higher (financials, technology), although there are always exceptions. As a result, a passive portfolio may be unintentionally weighted toward specific sectors or industries, resulting in greater tracking error and a less diversified portfolio.
As fund managers and data providers improve their ESG data collection and scoring, it likely will become possible for passive funds to overcome at least some of these issues, leaving investors with fewer excuses to avoid responsible investments. And obviously, time will tell if newer, less expensive ESG offerings will prove sustainable or attractive for investors.
However, with data and rating inefficiencies still rampant in ESG investing, it would be wise for investors to consider both fees and returns when evaluating their ESG options.
As with any investment, the cheap can become expensive if opportunity sets or higher-performing funds are ignored based on fees alone.
Now read this by Meredith Jones: This is one way Donald Trump has been good for the environment
Meredith Jones is an alternative-investment consultant and author of “Women of The Street: Why Female Money Managers Generate Higher Returns (And How You Can Too)”. Follow her on Twitter @MJ_Meredith_J.