ESG investing

How to choose an ESG fund: 'Don't trust the picture on the package,' expert says

Of the 88 funds with ESG in the name, about half get a D or an F from the nonprofit As You Sow.

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Investors are increasingly embracing ESG strategies — investments that allow you to earn a return on your money while investing in companies that rate highly on environmental, social, and governance issues. They put more than $51 billion into ESG mutual funds and ETFs in 2020 alone. And last year, those funds generally outperformed their non-ESG counterparts.

"I can save the world while earning competitive investment returns?" you may be thinking. "Sign me up!"

Choosing an ESG strategy that aligns with your values as well as your investing goals isn't as easy as typing "green ETF" into your brokerage search bar and hitting "Enter," though.  

"Think of ESG strategies the way you would think about food at a grocery store," says Edward Farrington, executive vice president of institutional and retirement at Natixis Investment Managers. "Don't trust the picture on the package. You have to read the ingredients."

Here's how to tell if you're investing in the kind of ESG fund you think you're signing up for.

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Know the basic varieties of ESG funds

At the end of 2020, investors had 369 ESG-related mutual funds and ETFs to choose from, per Morningstar. Deciding which one is right for your portfolio requires some consideration of your goals as well as the fund's, says Karen Wallace, Morningstar's director of investor education.

"The best answer for me would be a fund that's going to help me reach my investing goals," she says. "I want to feel like my portfolio is aligned with my values, which might mean lessening my exposure to things I find untenable while still remaining diversified and in line toward my goals."

You have a few different types of ESG funds to choose from.

Elimination funds

The oldest approach to ESG investing, "elimination" strategies seek to cut things out of a portfolio that may not align with investor values. Such funds may decline to hold stock in companies that earn significant revenues from alcohol, tobacco, or firearms, for example.

"Investing in these kinds of funds means that your portfolio reflect those exposures," says Andrew Lee, head of sustainable and impact investing at UBS Global Wealth Management. "You're signaling, but on an individual basis you're not affecting these companies. They're still doing what they're doing."

Integration funds

These mutual funds and ETFs incorporate ESG considerations into their investment strategy. Some funds may take a "best-in-class" approach, holding companies that score the highest among peers on ESG factors. Such strategies might hold large energy firms, for instance, if those companies have made significant investments in alternative energy.

Many funds use ESG as a framework to assess risk. Companies with clean environmental practices, for instance, are thought to be less susceptible to lawsuits or government regulations that could hurt business.

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Thematic funds

Thematic ESG funds invest directly in companies whose business objectives align with sustainability goals. Funds that focus on clean energy, for instance, might invest in firms that make wind turbines and solar panels.

Impact funds

Investors in impact funds are hoping to achieve measurable societal or environmental impact alongside a financial return. These funds may provide investors with literature showing how investor dollars have gone toward one or several of the United Nations sustainable development goals.

"These funds will often take significant stakes in companies and actively engage corporate management," says Lee. "It's about using the power of engagement and ownership to effect change."

It's about using the power of engagement and ownership to effect change.
Andrew Lee
head of sustainable and impact investing at UBS Global Wealth Management

Know what's in your ESG fund

It may not be readily apparent how a fund incorporates ESG factors into its strategy. Take the BlackRock U.S. Carbon Transition Readiness ETF, which attracted $1.25 billion of investor dollars when it launched in mid April. "The people who invested in that fund thought they were addressing climate risk," says Andrew Behar, CEO of shareholder advocacy nonprofit As You Sow. "Instead they got business as usual," he says, including energy and fossil fuel giants.

This is hardly unusual, says Behar. Of the 88 funds with ESG in the name, nearly half – 43 strategies – get a D or an F rating from As You Sow for their portfolio's exposure to climate change or deforestation. "If you buy a fund with ESG in the name, you expect it to do a little better," he says.

The first step investors should take in assessing any ESG investment is to figure out what the portfolio actually holds, says Behar, and determining which companies may or may not align with your values may be trickier than you think. "Think about banks," he says, pointing out that some of the most prominent ones fund deforestation in the Amazon rainforest.

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By entering a fund's ticker symbol into one of As You Sow's fund screeners, you can see how the organization scores the underlying holdings on factors such as fossil fuels, deforestation, gender equality, and exposure to private prisons. The nonprofit also maintains a list of mutual funds that score highly on its list of ESG factors.

Once you have an idea of what a particular fund holds, it's time to dig into the "recipe" behind the strategy, says Farrington. "The better way to think of the ingredients is the fund prospectus," he says. "What is their intent? How is this manager thinking about ESG factors, and how are they incorporating them?"

After doing your research, you may determine that a particular ESG fund fits into your investment picture, even if it includes some companies you find less than ideal. "Don't let perfection get in the way of finding your path," Behar says. "A fund might great on gender but could hold a company that's bad on weapons. No fund is perfect. The important thing is that your capital is being directed in a way that aligns with your values."

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