In the Harry Potter series, wizards are afraid to speak the Dark Lord’s name because it would break the spell and bring the antagonist back to power. This is the reverse of what happens in the investment world. Instead of “He Who Cannot Be Named”, the acronym ESG is repeated over and over and does the villain despite its limited impact, especially in the ETF space.
I came back last week from vacation in England and I realized that there was rarely a business day in August that the acronym ESG wasn’t in the news or my Twitter feed in a divisive way. We have had Florida and Texas prohibit companies for their ESG considerations; Strive launched a Energy ETFs push back against what he claimed was stakeholder capitalism by asset managers like BlackRock; asset manager Inspire removed the word “ESG” from its ETF suite, citing “the flames of intolerance”; and my friends and fellow ETF nerds Nate Geraci and Eric Balchunas shared Data it shows many Popular ESG ETFs have a high correlation to the S&P 500 Index, meaning the ETF’s performance was similar to popular non-ESG strategies.
Before I dive into some facts, I should note that my VettaFi colleagues Karie Gordon and Dave Nadig have written an excellent room titled “Is ESG Screaming in the Void”. The comment begins by saying:Few topics are more polarizing at a cocktail party bringing together the investment class than anything to do with informed environmental, social or governance (ESG) investing.
I’ve waited until now to clarify what Voldemort – I mean ESG – means because overuse of the acronym has obscured what we’re really talking about. When many people complain about ESG, they only focus on the environmental (E) pillar, especially climate change, but often nothing else.
The universe of ESG ETFs includes funds such as the iShares Global Clean Energy ETF (ICLN), Invesco Solar ETF (TAN)and SPDR S&P 500 ETF Without Fossil Fuel Reserves (SPYX), but also many other products. Indeed, there are 186 ESG ETFs by VettaFi at the end of August, i.e. around 6% of the universe. Many ETFs only take into account, or in combination with environmental characteristics, the attributes of the company related to the social or governance pillars.
Indeed, eight of the ten largest ESG ETFs take a broad indexing approach, including the iShares ESG Aware MSCI United States ETF (ESGU)the iShares MSCI USA ESG Select ETF (SUSA), and the Vanguard ESG US Stock ETF (ESGV). Other targeted ESG ETFs that go beyond the environmental pillar include ETF Catholic Global X S&P 500 (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 fund? Well, most ETFs track an index that uses unique criteria. However, the following is taken from the MSCI index methodology presenting the broad approach with ten notable themes and 35 key issues. Texas used MSCI ESG rating to compile its fossil fuel boycott list.
Themes used by MSCI include climate change, pollution and waste, human capital, product liability and corporate behavior. Meanwhile, the list of issues includes carbon emissions, toxic emissions and waste, employee health and safety, privacy and data security, financial consumer protection, business ethics, representation on the board of directors, etc. Even within each pillar, each company is scored for numerous attributes before being added to the portfolio; not just one focused on climate change.
For Harry Potter fans it’s like choosing the best wizards from Gryffindor, Ravenclaw and Hufflepuff, not just Slytherin, where Voldemort was from for those who have never read the books/seen the movies.
This multi-faceted approach is one reason why some of the largest ESG ETFs have larger holdings in the energy sector than the S&P 500 Index. For example, in late August, BlackRock ETFs ESGU and SUSA held 4.8% and 3.8% respectively in companies such as Baker Hughes, Chevron, Exxon Mobil, Halliburton and Valero Energy.
This should be good news for those who feared that ESG demand would dampen the potential of the US energy sector by forcing the company to join a social agenda imposed by ESG-related asset managers like BlackRock. (yes, I’m paraphrasing one of the firms that made headlines this summer).
Of course, being diversified and owning some energy and utility companies, not just communication services and information technology, tends to result in ETF portfolios that look like the market at a high level. . Indeed, many ESG ETFs seek to deliver performance that approximates that of the broader market by choosing the highest-rated companies in each sector while eliminating some companies and underweighting others.
Indeed, correlations of 0.99, 0.98 and 0.97 with 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. It’s something to be celebrated with a Butterbeer (another Potter reference, sorry), not ridiculed. (A correlation score of 1.0 shows that the strategy is perfectly in sync with the S&P 500 index.)
Relatively large ESG ETFs like ESGU and ESGV, and more moderately sized ETFs like SPDR S&P 500 ESG ETF (EFIV) and Goldman Sachs JUST US Large Cap Equity ETF (JUST)can be used as a core portfolio by ESG-conscious advisors without taking the risk of underperformance.
With all the attention on ESG, it may come as a surprise that the category represents just over $100 billion in assets, or around 1.5% of the US ETF asset base. In other words, 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 in the financial sector.
Interestingly, I haven’t heard any complaints about how this is preventing investors from getting the highest possible returns due to an ideological agenda that Florida has described as ESG.
ESG ETFs are a slice of the ETF market and a segment that some asset managers have focused their product development on. But while it may seem like the investing style is a battle of good versus evil where one side has to be taken, there is a third option. People can put down their Harry Potter wands and understand what these products have and how and why they have historically worked the way they have. And choose to buy them or not.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.