Global sustainable fund assets reached nearly $2.75 trillion at the end of last year, according to Morningstar data. At the same time, issuers launched more than 260 new ESG or sustainable funds during the fourth quarter alone. Unfortunately, many ESG funds don’t live up to their promise to exclusively invest in above-board businesses.
This article will examine how actively managed funds could overcome these problems and become the next sustainability leaders.
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ESG ETFs Fall Short
Vanguard’s ESG funds invested nearly one-third of their holdings in high-risk sectors, according to the Action Center on Race & the Economy (ACRE). For example, the funds’ portfolios own companies like Dow Chemical, which operates petrochemical facilities contributing to air quality issues in what’s now known as ‘cancer alley’ in Louisiana.
Of course, Vanguard isn’t the only offender. The iShares MSCI USA ESG Select ETF (SUSA) owns six oil and gas companies and four fossil-fuel-fired utilities, including Baker Hughes and Valero Energy. These holdings may not be apparent to investors who don’t read the ETF’s prospectus and invest solely based on the ‘ESG’ moniker.
A more significant problem is that even well-designed ESG funds diverting money away from dirty companies may not have a net-positive impact. The race to divest fossil fuel assets is pushing them into the hands of private equity funds that don’t have to comply with environmental disclosures, enabling them to do more damage.
There’s also evidence that ESG funds don’t always vote for ESG proposals. Last year, researchers found that the Vanguard Social Index Fund (VFTAX) voted against almost all environmental and social resolutions between 2006 and 2019. Both Vanguard and Blackrock also voted against board diversity proposals at Apple, Facebook, and other large firms.
Why Hands-On Is Essential
The problem with passive ESG funds is that there’s no easy way to measure environmental, social, and governance impact. In an ideal world, ESG funds would be composed of companies taking action to combat climate change or improve social equity. That might include solar panel manufacturers or utilities making a clear effort to embrace renewables.
Active managers can better assess these opportunities individually and follow up with them over time. For example, Engine No. 1’s Transform Climate ETF (NETZ) invests in companies that will drive and benefit from the energy transition. Rather than relying on ESG criteria, the team focuses on conviction positions in industries that need to decarbonize.
In addition to targeting specific investments, active managers can harness the power of proxy voting to effect positive change. For example, NETZ works with management teams at some of the most polluting companies to push for positive change. And the firm already has one win under its belt following its proxy battle with Exxon Mobil.
Other funds exclusively invest in companies taking climate action. For instance, the JPMorgan Climate Change Solutions ETF (TEMP) invests in companies providing solutions or implementing business practices in response to climate change. These include investments in sustainable construction, renewable energy, and recycling and reuse.
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The Bottom Line
Global sustainable fund assets are on the rise, but many ESG funds don’t deliver on their promises to shareholders. While asset managers could improve their ESG criteria and voting records, only active managers have the flexibility to individually select the most promising companies and maximize the power of their votes to effect change.
Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.
