Environmental, Social, and Governance (ESG) Funds Overview
What are ESG Funds?
Adding to the menu of investments available, ESG funds are a category of funds that focus on environmental, social, and governance principles. ESG funds provide an opportunity to invest in causes that are deemed ethical or bring ‘good’ to the world.
However, just as ethics and morality can quickly become complex, so too can the scope of ESG funds. Many differentiators can cause two funds with the ‘ESG’ title to be very distinct. For example, ESG funds can focus on one or more of the ESG components and be structured as an ETF or a mutual fund. The methods used to create ESG funds are not standardized, and more than 800 ESG mutual funds and ETFs are available to U.S. investors. Between 2018 and 2022, the number of new ESG funds introduced to the market each quarter has quadrupled, exemplifying the growth in popularity of these funds over the last several years. In this article, we will touch on the common categorizations of ESG funds and the current landscape of these funds to bring some clarity to the pool of ESG funds available.
Underpinning most ESG funds is the use of ESG scores to evaluate potential investments. Public information regarding environmental, social, and governance criteria are used to assign scores, with high scores equating to better performance in those areas. Fund managers can create a proprietary method for scoring, though they typically utilize scores created by rating agencies and non-governmental organizations when selecting their investments. Unfortunately, there is no standard framework for ESG scoring. However, common frameworks come from sources such as the Global Reporting Initiative (GRI), the Sustainability Accounting Standards Board (SASB), and the Principles for Responsible Investment (PRI). These scores are then used as a reference point for selecting investments and creating ESG funds.
Composition of ESG Funds
As with all funds on the market, each ESG fund has an investing strategy that defines the criteria used to select investments for the fund. The approach used to create ESG funds often falls into one of four categories: exclusionary, inclusionary, ESG integration, or portfolio tilt.
- The exclusionary ESG fund strategy, also called negative screening, focuses on particular sectors or types of companies to exclude from the fund. Examples of exclusionary criteria include prohibiting oil, weapons, or tobacco companies.
- Inclusionary ESG funds frame selection as including companies that align with their criteria, such as companies with certain ethical or sustainable practices or simply funds with high ESG scores.
- The inclusionary strategy aims to choose investments to support ESG initiatives, while the exclusionary screening mentioned above focuses on avoiding investments that will have a negative impact on the ESG components.
- ESG Integration
- ESG integration weaves together ESG data and traditional financial analysis. For example, analysts would use this strategy to evaluate a company’s carbon emissions alongside its profitability. Rather than considering ESG factors separately from the traditional fund analysis, it is embedded in the selection process.
- Portfolio Tilt
- Finally, portfolio tilt is a strategy often used in ESG ETFs, where the fund has a larger percentage of investments with high ESG scores while conserving the sector weights that align with their target index. Maintaining the weighting of sectors creates similar risk-adjusted performance.
- For example, in the S&P 500 ESG Tilted Index, companies in the S&P 500 are grouped by sector, and those with the highest ESG scores within each industry are weighted more heavily. This results in a tilt towards higher ESG scores while conserving the original sector weighting. This particular ESG index does employ the use of exclusionary criteria as well, though portfolio tilt is the primary strategy.
Recognizing the common categorizations of ESG fund composition is a helpful way to differentiate between the many funds on the market.
Direct Indexing for ESG Investing
As an alternative to investing in the existing ESG funds available, investors can use direct indexing as a more personalized approach with the ability to filter out unwanted categories down to the security level. In direct indexing, the investor replicates an index by purchasing the underlying stocks of the index. This method allows investors to follow an index and overlay their personal ESG preferences. In addition, direct indexing allows for tax loss harvesting, which is generally more difficult with ESG ETFs as fewer are available. However, direct indexing typically has a higher barrier to entry, seeing as a larger minimum investment is needed to implement this strategy.
Current Landscape and Considerations
Despite grouping funds by the composition styles above, narrowing down to a preferred ESG fund can still be quite tricky. This is largely due to the unregulated nature of both the ESG scoring systems and the use of the ‘ESG’ title on funds. Without a standardized method for scoring companies and ESG funds, investors looking for funds fully aligned with the spirit of ESG investing must dive deep into each fund to understand the scoring and composition, which can be very time intensive. Furthermore, companies and funds alike have been accused of overestimating the sustainable or ethical practices they purport, a tactic known as “greenwashing.” The SEC proposed changes to address these issues. If the proposed changes take effect, this may reduce confusion and allow investors to find funds that align with ESG principles more easily.
ESG funds provide a unique vehicle for investing in environmental, social, and governance-focused opportunities. ESG scores offer a method of quantifying performance in these areas, and the strategic direction of ESG funds often falls into one of the categories above. While these two components are valuable tools for understanding the many ESG options available, the lack of regulation poses challenges. The market for ESG funds is far from stagnant and will be an interesting area to witness changes in regulatory oversight and future development.