Saving For Your Future: ESG Funds Explained
CNEP informs our readers about global warming, carbon emissions and actions they can take to mitigate the effects of climate change. However, dispensing investment advice is not our profession! This note, therefore, is an overview of what some investors are doing to direct their savings and investments in an “Earth-friendly” fashion. We point to where you might get professional advice and we provide some of the vocabulary for these investment styles.
Definitions first: ESG: Environmental investing is co-located with ‘positive’ Social and Governance activities.
E: carbon emissions, water stress, toxic emissions, and waste
S: labor management, health and safety, human capital development, and privacy and data security
G: corporate governance, business ethics, corruption and instability, and anti-competitive practices
This author suspects the “ESG” corporate behaviors are grouped to simplify bankers’ lives by shooing all the needs of liberal investors into one box! One of Vanguard’s ESG Funds uses this broad definition “the exclusion of certain companies that derive any revenue from involvement in controversial weapons, civilian firearms, nuclear power, or fossil fuels and the exclusion of certain companies that derive any revenue from the production of tobacco or conventional military weapons…” This is an Exclusionary fund. All other investments are allowed. We note that in this ESG fund “Governance” is not addressed, just two social causes (tobacco & weapons and firearms) and two environmental causes (nukes and fossil fuels), only one of which is a contributor to global warming. Other typical fund exclusions might preclude investments that involve pornography, Artificial Intelligence, dual-class share structures, resource depletion, hydrocarbon usage, exploitative labor practices, etc.
In contrast, Inclusionary funds invest in firms (typically via stock or debt) with “leading environmental, social, and governance (ESG) practices” and “the advisor will engage with company management and vote proxies” that support ESG matters put before shareholders. Further forward in terms of active push for good are Impact funds which want to invest to fund specific beneficial intent. One Impact fund’s intent is to invest in “global high quality growth companies which can deliver positive change in one of four areas: Social inclusion and Education, Environment and Resource Needs, Healthcare and Quality of Life; and Base of the Pyramid (addressing the needs of the world’s poorest populations).”
In general, Exclusionary funds hold investments in more companies, Impact Funds hold the fewest, with Inclusionary funds in the middle. They can be established to invest in international or domestic securities, hold equities or debt, or have other slices of variation that one sees in the universe of funds. Fees are generally a bit higher than equivalent generic mutual funds - - a point argued is merited by the managers’ research efforts to keep your money out of badly-behaved companies, or in good companies. “Companies” are normally the vehicle of end investment: Sovereign country or municipal debt or is rarely subject to ESG metrics in funds typically offered to retail investors.
So this dimension of the matrix is now:
What are the returns for these choices?
One widely cited academic study¹ concluded that: “Aggregating environmental, social, and governance into a total ESG rating added value in terms of performance and risk. Governance indicators showed the greatest significance in the short term because they have tended to materialize as event risks that immediately affected stock prices. However, some E and S indicators developed slowly but have had long-lasting financial effects.”
Looking at 2006-2019 data, this study assessed the top 20% of E, S, G and ESG companies vs. the 20% lowest ESG Score companies. Well-governed companies (good G) contributed most quickly to returns and risk reduction, while good Social and Environmental behaviors had slower but eventually positive effects. Top 20% of Companies that had strength in all ESG aspects did better than individual E, S or G leaders. See “Exhibit 9” from this study:
So, we cannot tell from this if the good behaviors (E, S, & G) cause better performance, or if companies with good performance can afford the good behaviors, the management time and costs of which may be material. Only time will tell if ESG factors improve returns. 2022-2023 was a period of underperformance for ESG funds generally. By February 2024, they had caught up.²
Further, there is a risk that ESG Fund managers may not always “do the right thing”. A recent analysis by Morningstar indicates that some ESG fund managers do not use their control over voting rights to push companies towards approval of ES or G resolutions at annual meetings.³ Vanguard has implemented a means to allow investors to indicate their own voting preferences (or indifference/opposition) to ESG proposals at portfolio companies within their Funds.⁴ Blackrock, another huge investment manager is pursuing similar means to let investors direct their own ESG issue intentions.
ESG is NOT the Market
Professional money managers and others worry that ESG selection will result in an atypical portfolio, one that might underperform “the Market” in certain years. The NY Times reports that ESG stock funds have a “Growth Fund” bias as they are overweight Tech company shares.⁵ This makes sense as heavy-polluting and carbon-emitting companies tend to be older companies in lower-growth industries. Thus ESG funds will have less exposure to these old sectors, which can be good sometimes, and at other times, not as good. Conservative lawmakers have used this as an argument to keep State investment and pension funds out of ESG funds – claiming that only investment returns should drive investment choices. For Red State pension funds, they shape the investment decisions. We, however, can invest away from Big Oil, bad labor practices, overpaid CEOs and two-tier voting. ESG funds may help by screening out or screening in investments based on specific ESG criteria.
The Big Picture
As the economist Keynes once said “Well in the long run, we are all dead.” To which we add, “Yes, but CNEP readers have a longer view.” For older readers, the worst potential impacts of a globally-warmed future may indeed outlast our portfolio value or ourselves. So in this way, using ESG investing as one more “while we are here” means of being good citizens is essential to consider: “First do no harm” (Exclusionary Fund) then, “Do some Good” (Inclusionary Fund), and for some of our investible funds “Focus on Good Works” (Impact Funds.)
Morningstar research tracks ESG funds news at: https://www.morningstar.com/sustainable-investing
Speak to your professional investment advisor prior to investing. These opinions are not intended as investment advice.