In the Harry Potter Series, the wizards are afraid to utter the name of the Dark Lord because to do so would break the jinx and bring the antagonist back to power. This is the reverse of what is happening in the investment world. Instead of “He Who Cannot Be Named,” the acronym ESG is being said repeatedly and made the villain despite its limited impact, particularly in the ETF space.
I came back last week from a vacation in England and realized that rarely a business day went by in August when the acronym ESG was not in the news or my Twitter feed in a divisive way. We had Florida and Texas ban companies for their ESG considerations; Strive launched an energy ETF to push back what it claimed was stakeholder capitalism by asset managers like BlackRock; asset manager Inspire dropped the word “ESG” from its suite of ETFs, citing “flames of intolerance”; and my friends and fellow ETF nerds Nate Geraci and Eric Balchunas shared data that shows many popular ESG ETFs have a high correlation to the S&P 500 Index, meaning the ETF performance was similar to the widely popular non-ESG strategies.
Before we dive in with some facts, I should note that my VettaFi colleagues Karie Gordon and Dave Nadig wrote an excellent piece titled “Is ESG Screaming Into the Void.” The commentary starts by stating, “Few topics are more polarizing at a cocktail party full of the investor class than anything related to environmental, social, or governance (ESG) informed investing.”
I waited till now to spell out what Voldemort – I mean ESG – stands for because the acronym’s overuse has masked what we are really talking about. When many people complain about ESG, they focus solely on the Environmental (E) pillar, particularly climate change but often nothing else.
The ESG ETF universe includes funds like the iShares Global Clean Energy ETF (ICLN), Invesco Solar ETF (TAN), and SPDR S&P 500 Fossil Fuel Reserves Free ETF (SPYX), but also many other products. Indeed, there are 186 ESG ETFs per VettaFi as of the end of August or approximately 6% of the universe. Many ETFs take company attributes tied to the Social or Governance pillars solely, or in combination with Environmental traits, into account.
Indeed, eight of the ten largest ESG ETFs take a broad index-based approach, including the iShares ESG Aware MSCI USA ETF (ESGU), the iShares MSCI USA ESG Select ETF (SUSA), and the Vanguard ESG U.S. Stock ETF (ESGV). Other targeted ESG ETFs that focus beyond the Environmental pillar include the Global X S&P 500 Catholic Values ETF (CATH), the SPDR SSGA Gender Diversity Index ETF (SHE) and the WisdomTree Emerging Markets ex-State Owned Enterprises Fund (XSOE).
So what makes a fund an ESG one? Well, most of the ETFs track an index that uses unique criteria. However, the below is pulled from the MSCI index methodology showcasing the broad approach with ten notable themes and 35 key issues. Texas used MSCI’s ESG scoring to put together its fossil-fuel boycott list.
The themes used by MSCI include climate change, pollution and waste, human capital, product liability, and corporate behavior. Meanwhile, the issues list consists of carbon emissions, toxic emissions & waste, health & safety of employees, privacy & data security, consumer financial protection, business ethics, board representation, and others. Even within each pillar, each company is scored for many attributes before being added to the portfolio; not just one focused on climate change.
For Harry Potter fans, this is like choosing the best wizards from Gryffindor, Ravenclaw, and Hufflepuff, not just Slytherin, which is where Voldermort was from for those that never read the books/saw the movies.
This multi-faceted approach is one of the reasons that some of the largest ESG ETFs have more meaningful stakes in the energy sector than the S&P 500 Index. For example, in late August, BlackRock’s ETFs ESGU and SUSA had 4.8% and 3.8%, respectively, in companies like Baker Hughes, Chevron, Exxon Mobil, Halliburton, and Valero Energy.
That should be good news for folks that were worried that the demand for ESG was going to dampen the potential of the U.S. energy sector by mandating the company adhere to a social agenda imposed by ESG-linked asset managers like BlackRock (yes, I’m paraphrasing one of the firm’s that has made headlines this summer).
Of course, being diversified and owning some energy and utilities companies, not just communications services and information technology ones, tends to result in ETF portfolios that look similar to the market at a high level. Indeed, many ESG ETFs seek to deliver performance close to that of the broader market by choosing the highest-scoring companies within each sector while removing some companies and underweighting others.
Indeed, the 0.99, 0.98, and 0.97 correlations to the S&P 500 Index by ESGV, ESGU, and SUSA are precisely what asset managers BlackRock and Vanguard, and their index partners, had in mind. This is something to be celebrated with a Butterbeer (another Potter reference, sorry), not ridiculed. (A correlation score of 1.0 shows the strategy is perfectly in sync with the S&P 500 Index.)
Relatively large ESG ETFs like ESGU and ESGV, and more moderately sized ones like SPDR S&P 500 ESG ETF (EFIV) and Goldman Sachs JUST U.S. Large Cap Equity ETF (JUST), can be used as the core of a portfolio by those ESG-minded advisors without taking on the risk of underperformance.
Because of all of the attention ESG gets, it might be surprising the category represents just over $100 billion in assets or approximately 1.5% of the U.S. ETF asset base. Said another way, there are more ETF assets in the Invesco QQQ Trust (QQQ), which owns large-cap growth companies but only those listed on the Nasdaq and none within the financials sector.
Interestingly, I have not heard complaints about how this limits investors from obtaining the highest possible returns due to an ideological agenda that Florida has described ESG.
ESG ETFs are a slice of the ETF market and a segment where some asset managers have focused their product development. But while it might seem like the investment style is a battle of good versus evil where a side needs to be taken, there’s a third option. People can put down their Harry Potter wands and understand what these products own and how and why they have historically performed as they have. And choose whether or not to buy them.
For more news, information, and strategy, visit the ESG Channel.