Sustainable Investing: How to make sure your ESG fund does what you think it does

Mutual Funds

One factor that makes responsible investing difficult for investors is the linguistic anarchy that surrounds it. Investors, asset managers and advisers tend to liberally apply terms like ESG, even when it may not fully reflect the investment strategy or fund in question.

The resulting terminology soup unfortunately provides the perfect breeding ground for investor confusion as well as disappointment when a chosen investment fund doesn’t behave as expected.

Here are some of the key terms and investment strategies that fall under responsible investing:

ESG: This is short for Environmental, Social and Governance and is the current “it” phrase in responsible investing and, as such, is sprinkled liberally on investment products and managers, sometimes with seeming abandon.

ESG means that a fund or fund manager looks not just at the financial data, such as price-to-earnings ratios, earnings growth and cash on hand, but also at nonfinancial data (usually related to environmental, social and governance factors) to determine whether an investment has strong prospects for growth or might falter in the future.

This doesn’t require the divestment from or avoidance of specific sectors, including fossil fuels. But if pending or current regulation or significant investor ostracization due to environmental or social factors made an industry unviable, for instance, it would be excluded from an ESG strategy based on that nonfinancial data.

Now let’s look at Facebook

FB, -1.27%.

While the company has a low carbon footprint (good E), some fund managers might exclude it due to concerns about consumer privacy (S), lack of transparency about how data is shared (G) or even concern over future regulation of data privacy.

Most research shows ESG strategies produce returns similar to or slightly better than non-ESG investments.

Also read: When stock markets turned turbulent, ESG funds punched above their weight

SRI: This stands for Socially Responsible Investing, which is a type of values-based investing. When funds or investors engage in SRI, they generally eschew specific industries and sectors they find unpalatable based on their, or their organization’s, values.

Faith-based investing is a classic type of SRI; investment choices are dictated by the values of a particular faith. In Catholic investing, for example, you might find that companies that provide birth control are excluded. In Shariah-compliant investing, companies that profit from the generation of investment interest would be omitted from the portfolio.

More: When your faith guides your investing decisions, can you still beat the stock market?

Funds that avoid fossil fuels are also classic SRI strategies.

At least one meta-study of SRI investment performance showed no discernible difference between SRI fund performance and traditional investments. However, depending on the size and performance of the sector(s) being excluded, there may be increased tracking error or active risk in SRI funds.

Impact investing: Here, an investor or fund manager wants a certain outcome, or impact. A fund that focuses on the United Nations Sustainable Development Goals (such as eliminating poverty, eliminating hunger, creation of sustainable cities and communities and reduction of inequality) would generally be defined as an impact fund. Funds that focus on gender, diversity, renewable energy, cancer cures and other desired outcomes would also fall into the impact bucket.

Investors are generally looking for a market return as well as a measurement of, well, its impact, or how well (or poorly) a fund is achieving the desired outcome.

Read: How impact investing can create affordable housing

A reality check

While these definitions are fairly straightforward, industry participants — from fund managers to investment media to advisers — historically haven’t strictly adhered to them.

For example, many of these funds are often grouped under the ESG umbrella, but they contain elements of multiple responsible investment techniques. Based on a review of fund prospectuses, for example, we can see that many fund managers take a fairly broad approach to responsible investing strategies.

Fund name Ticker symbol ESG approach SRI approach Impact approach
Xtrackers MSCI USA ESG Leaders Equity ETF USSG Yes Excludes firearms, tobacco, alcohol, gambling, some weapons No
Goldman Sachs JUST U.S. Large Cap Equity ETF JUST Yes – many of the “just” business behaviors correlate to elements of ESG investing No Job Creation
Beneficial Products
Vanguard ESG U.S. Stock ETF ESGV Yes Excludes adult entertainment, alcohol, tobacco, weapons, fossil fuels, gambling and nuclear power. Also excludes companies that don’t meet U.N. Global Compact principles and diversity criteria No
TIAA CREF Social Choice Equity Fund TISCX Yes Excludes thermal coal, firearms, gambling products and services, alcohol, tobacco, military weapons and nuclear power No
Tortoise Global Water ESG Fund TBLU Yes – must meet minimum ESG criteria No Yes – companies “make conscientious efforts to positive impact the world environmentally [and] socially”
Domini Impact Funds DSEFX, DOMIX, DSBFX Yes Yes – weapons and firearms, nuclear, oil and natural gas, coal mining, tobacco, alcohol and gambling Yes – the fund “may also invest in companies that Domini believes help create products and services that provide sustainability solutions”
iShares MSCI ACWI Low Carbon Target ETF CRBN Yes Yes – high carbon Yes – encourages companies to transition to low carbon future

While there is nothing inherently wrong with a “big tent” RI approach, investors looking for a straight ESG approach may be surprised to find additional active risk in their returns if they aren’t aware of a fund’s exclusionary investment practices. Likewise, if a fund states that impact is a goal, it should be held to both performance standards and impact metrics such as job creation, socioeconomic improvements and increased diversity.

Even with these broad definitions, there isn’t widespread industry agreement about what nonfinancial factors are material to a company’s trajectory. Some funds may rely on strictly quantitative ESG scoring, which can be provided by a number of providers, such as MSCI, Sustainalytics and FTSE-Russell. Other funds may rely on proprietary ESG measures driven by internal quantitative measurements plus information gathered from company management.

As a result, the weighting of different environmental, social or governance factors may vary from fund to fund.

Finally, investors need to understand that different fund managers may be more liberal or conservative with screens and exclusions. For example, a fund that excludes firearms may simply exclude the roughly 20 publicly traded and over-the-counter firearms and munitions stocks, or it may also exclude retailers such as Walmart

WMT, -1.55%

 , which sells 20% of the ammunition in the United States.

While responsible-investing multitasking isn’t an innately bad investment approach, it is important for fund managers to be upfront and transparent about inclusions and exclusions as well as RI investing methodologies and latitude.

In addition, investors should carefully review the investment prospectus for any fund, but particularly responsible-investing funds, prior to investing to fully understand exactly how their RI fund invests. Failure to do so could result in some unhappy surprises down the road for both parties.

Also read: Blame your index fund for why companies don’t do more to fight climate change

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.

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