Chapter 17
Investing for a Better World
IN THIS CHAPTER
Unearthing some facts about sustainable investing
Delving into the history of “do-good-do-well” funds
Defining what “ESG” is, and what it isn’t
Choosing your best options for responsible investing through ETFs
How’s the temperature where you are? A bit extreme? Global climate disruption is but one of the world’s problems that has helped jostle millions of investors worldwide to move their money into investments that promise to provide more than just financial returns. These investments offer a chance to help combat climate change, end child labor, improve corporate-board diversity, and make the planet a cleaner, kinder, safer, more equitable place in myriad ways.
How many millions have been so jostled? Millions of millions. More than $35 trillion so far has been plunked into investments whose managers employ some kind of moral compass, according to the Global Sustainable Investment Alliance. Those trillions represent about 36 percent of all investment assets, and this figure has been rising fast. That grand sum represents money invested through endowments, trusts, institutional portfolios, mutual funds… .and, growing perhaps fastest of all, ETFs.
There are now about 150 ETFs that focus specifically on sustainable investing, with combined assets of just about $100 billion. That’s up from 91 ETFs that together held a mere $54 billion just one year earlier, according to Morningstar Direct.
What Are “Sustainable Investing” and “ESG”?
Once upon a time, today’s sustainable or ESG funds were generally referred to as SRI or socially responsible funds. But times change, and with them, the terminology investors use. SRI is barely used today. Instead, you’ll hear about a fund that invests sustainably — with an eye toward creating a better planet and a healthier society — or you’ll hear about ESG funds. ESG, among those savvy in the field, actually describes an approach to measuring sustainability. Within the ESG framework, issuers of stocks and bonds are rated according to three criteria:
- E stands for Environment. Companies get points for complying with governmental environmental regulations, and operating in a manner that doesn’t contribute to climate change, deforestation, and pollution of air, water, and soil.
- S stands for Social. Better companies promote fair labor practices, employee diversity, safe working conditions, and the health and well-being of the public. Better companies’ workers are paid living wages and given decent health benefits.
- G stands for Governance. The best corporations don’t employ heavy-handed lobbying or bribe government officials. They diversify their boards and use transparent accounting methods. Those in charge work in the best interests of shareholders, employees, and customers.
Sustainable investing is sometimes filled with ambiguity
Is everyone in agreement as to the criteria that cause one company to have a high ESG rating and another company a low ESG rating? No. The world is still looking for objective measures, and in the meantime, corporate leadership and investment-fund managers have a lot of — perhaps too much — latitude in defining sustainability. And there is all too often a difference in what the managers of sustainable funds are doing and what their investors think they are doing.
Detractors of sustainable investing and ESG methodology (more accurately, methodologies) say that this lack of uniformity and the occasional profiteer (“greenwasher”) are reasons to avoid sustainable investing. That is just silly. Just because Car and Driver and Consumer Reports don’t necessarily agree on whether Toyota or Subaru produce the better sedan doesn’t mean that you shun Toyota and Subaru or that you don’t seek guidance from experts on the best car to purchase.
Sustainable investing is a great concept. And if you wonder if you can do well financially by doing good, I’m here to say, “Yes, yes, you can.”
Are companies with better ESG ratings more profitable?
Keeping in mind that ESG ratings and definitions differ, can the argument nonetheless be made that companies that really care about the world around them do indeed have more robust bottom lines? It would make sense that companies that think sustainably have greater long-term vision, aren’t making stupid decisions for short-term profits, and display sensibilities to others and the planet that could build long-term loyalty among workers and customers, with an end result of greater profitability. And studies show this is the case.
Researchers at the NYU Stern Center for Sustainable Business, in cooperation with Rockefeller Asset Management, recently compiled 1,000 studies on the subject. They found that 58 percent of the studies showed a positive relationship between ESG and corporate financial performance, whereas only a handful (8 percent) showed an inverse relationship. (The remainder of the studies were either neutral or mixed.) The longer the time frame, the more likely that companies with a focus on ESG tended to be profitable.
Is ESG investing creating a better world?
ESG is a methodology or methodologies by which fund managers rank companies from great to good to mediocre to poor to horrible world citizens. Such ranking is often the first task of the manager of an ETF that promises you can do good by doing well. But ETFs that call themselves sustainable or ESG use differing methods to promote ethical and ecological goals.
Just as artists use different tools and different materials to create paintings and sculptures, fund managers use different strategies to invest so as to create financial return and return for the planet. These tools and materials are often integrated (you’ll hear the term “ESG integration”) but may also be used solo. They include the following.
- Exclusions: Let’s use ESG ratings to identify companies that do the world more harm than good and then avoid investing in them.
- Positive screening: Let’s again use ESG ratings, but this time, to invest only or primarily in companies doing right, or at least that are “best in class” among companies in the same industry.
- Active ownership: Let’s arm-bend company leadership to become better world citizens, perhaps by raising a ruckus at shareholder meetings.
- Thematic investing: Let’s invest in industries like solar and wind power, recycling, and public transportation.
- Impact investing: Let’s find specific ventures or projects to promote. Impact investing is often used by ETFs that invest in “green bonds” — bonds used to raise money for ecologically minded projects.
To date, sustainable ETFs have used exclusions more than any other strategy, but that seems to be changing, as more fund managers and investors realize that that strategy alone is suboptimal, and to have the most positive effects on the world and investment returns, it may pay to use several strategies. I feel confident in saying that in the aggregate, these strategies have succeeded in making positive world change.
The ESG movement has undoubtedly had an impact on corporate America, notably by pushing certain auto, oil, chemical, and utility companies to reduce pollutants. Other victories include a nationwide ban on mercury thermometers and commitments from various corporations to start reducing greenhouse gas emissions, start recycling programs, and end discrimination against employees based on their sexual orientation.
And with $100 billion invested in ETFs that focus on sustainability — and growing fast — the pressure exerted by ETFs to create a better world will certainly grow.
Will investing in ESG funds make you rich?
The oldest ESG ETF is the iShares MSCI USA ESG Select ETF (SUSA), which was started on January 24, 2005. Since inception, the fund has returned a healthy 10.2 percent a year. In the past 5 years, the fund has returned 19.3 percent, while the total U.S. stock market has returned 18.0 percent. And moving along the spectrum, SUSA thoroughly trounces the USA Mutuals’ VICE mutual fund (VICEX), which actually seeks to invest in socially irresponsible companies! (No, you will not find VICEX included in any of my sample portfolios presented later in this book. Invest in sin on your own!) That fund has returned a meager 4.6 percent over the past 5 years. Do these comparative returns mean you’re always going to do better with ESG funds?
No.
Lately, almost all ESG funds have clobbered all non-ESG funds, never mind this one ridiculous anti-ESG fund. It isn’t because the ESG funds are ESG funds per se. It is largely because ESG funds, as a rule, underweight energy companies (which have tanked in past years) and overweight tech (which has soared in past years).
ESG is not an asset class. ESG funds may have stock portfolios, bond portfolios, domestic portfolios, and foreign portfolios. All of these are asset classes, and will generally play a much bigger role in the risk and return of a fund than whether it is an ESG fund or just a plain-vanilla ETF.
In the very long run, ESG funds of a certain asset class will probably not do much better or worse than non-ESG funds of the same asset class. That’s because markets tend to be efficient. In other words, if highly rated ESG companies were to consistently outperform non-ESG companies (as studies indicate may well happen), then investors’ money would steadily pour into the ESG companies, and their stock prices would rise. Hence, paying more for the stocks would temper stock performance. This is why stocks in growth companies, which are overall healthier and more profitable than value companies, don’t outperform in the long haul.
Fence-sitters, make a decision
So should you go out of your way to invest in ESG funds? For years, this was a tough question for me. Many ESG funds in years past simply charged too much. Or I didn’t feel that they were necessarily managed in a way as to maximum return while minimizing risk. One especially annoying feature of broad ESG bond funds in the past was their tendency to charge investors a hefty fee for screening the corporations, while the fund actually carried mostly Treasury bonds.
But that has all changed in the past several years. Most ESG funds today cost roughly the same as their non-ESG counterparts. Some are even cheaper! And they are managed (passively or actively) by the best in the business.
According to a Morgan Stanley report from 2019, “[r]esearch conducted on the performance of nearly 11,000 mutual funds from 2004 to 2018 show[ed] that there is no financial trade-off in the returns of sustainable funds compared to traditional funds.” (They used mutual funds and not ETFs because back in 2004, there were so few ETFs.) The Morgan Stanley report not only found comparable performance between ESG and non-ESG funds, but they also concluded that the ESG funds were slightly less volatile, and less likely to tank when markets turned south. Other studies have noted the same slight advantage in stability.
So if you can invest in a way that could make the world a better place, and your portfolio isn’t going to suffer for it, and may actually benefit by slightly reducing risk, why not do so? And that is why, throughout this book, where I recommend ETFs, you often find ESG ETFs. In the rest of this chapter, I recap some of those recommendations, along with a few funds I haven’t yet showcased.
Which Sustainable ETFs Are Best for Your Portfolio?
Keep in mind, once again, that sustainability and ESG criteria are not asset classes. All ETFs, regardless of whether they have a focus on ESG, are nothing but baskets of securities, usually stocks or bonds. So the first question for you, if you want to “ESG-ize” your portfolio, is, “What kind of investment do I want?” Stocks? Bonds? Domestic? Foreign? Large cap? Small cap? I address these questions in Parts 2 and 3 of this book.
Once you’ve decided what asset class or classes you want to invest in, you can shop for an ESG fund that offers that asset class. Of course, you’ll want a fund that is likely to earn you a good return. Start by looking for low costs. And, of course, you want to know that your money is making a difference. Here is where ESG funds, and the strategies they use, can vary enormously.
The most popular strategy used by ESG funds to date, as I mentioned before, has been exclusions — avoiding investments in companies, and sometimes industries, such as tobacco and pornography, where the benefits to society are dubious, to say the least. Some of these funds have done a better job than others. Some, quite honestly, have been awfully lax in their screenings. Companies have been given gold stars not for having taken any positive actions, but merely for having made vague promises to do so. Some ESG strategies used by some ETF managers exclude only 10 percent of the U.S. stock-issuing corporations.
Even more troubling, some of the ETF purveyors promoting ESG funds actually have pretty terrible records where it comes to using their voting power to promote ESG initiatives, and these include the two largest providers of ETFs: iShares (BlackRock) and Vanguard. “These companies are powerful, and could make a huge difference, but they haven’t been,” says Jon Hale, director of ESG strategies for Morningstar.
Research done by Hale, along with Morningstar’s Jackie Cook, based on 2020 proxy voting, found that both of these ETF giants voted against ESG proxies far more than they voted for them. “It isn’t that fund managers love polluters,” says Hale, “it’s just that they vote most often in favor of whatever the board suggests.” And it has long been known that executives of U.S. companies, in part because of how they are compensated, focus too much on short-term profits and not on bigger or more long-term issues.
But that, says, Hale, is destined to change. “BlackRock especially has heeded the criticism [that came from Hale’s study], and they are starting to do better,” says Hale. In fact, as I’m writing this chapter, I opened up the Wall Street Journal (August 13, 2021) while drinking my morning coffee, and read that BlackRock, in the first half of 2021, backed 64 percent of environmental proposals, up from 11 percent in 2020.
“And Vanguard?” I asked Hale. Nothing but silence on the other end of the phone line. As a lifelong fan of Vanguard, I must say that this deeply disappointed me.
ETF purveyors that already had good track records in 2020, as reported in Hale’s study, include Nuveen and Xtrackers (Deutsche Bank).
Hale says it can be difficult to uncover a fund manager’s proxy voting record, but it isn’t impossible. Funds have to file how they voted with the SEC, and they generally post these documents somewhere on their websites. Morningstar Direct, a pay service, can also provide this information. As for other measures that an ETF is taking to promote a better world, you’ll want to read up on them carefully. Every ESG fund’s sponsor has a website with loads of information, including the holdings of the fund and specific strategies the managers are using to promote a better world.
In the following sections, I cover a few funds that I feel fit both categories: good investments and good for the world. Note that there are about 150 ETFs that focus on sustainable investing. Many are discussed throughout this book. (Even when choosing an ETF that doesn’t focus specifically on sustainable investing, you can often find an ESG rating online [from various ratings groups] to help guide you in your choices.)
Engine No. 1 Transform 500 ETF (VOTE)
Inception date: June 22, 2021
Management fee: 0.05 percent
Investment focus: This is an index fund tracking the Morningstar US Large Cap Select TR USD Index, a market-weighted index of 500 of America’s largest public corporations (quite similar to the S&P 500).
ESG strategy: “You can’t solve a problem by running from it… . Too many sustainable funds exclude companies that need to change rather than changing them,” say the fund managers of Engine No. 1. In other words, they willingly buy up polluting companies with the aim of changing them for the better using proxy voting and other strong-arm methods of influencing the boards. These are the folks who run a San Francisco-based hedge fund and in June 2021 were able to nominate three director positions to the (12-member) board of ExxonMobil. And then, by exerting influence on other shareholders, they got their three directors elected. The directors are not out to dismantle the oil giant, but rather to get it to grasp the reality of climate change, and by doing so, to help protect both the planet and itself.
Russell’s review: Given that this index fund tracks an index much like the S&P 500, you can expect long-term performance in line with the S&P 500. And at only 0.05 percent in management fees — you can’t do much better than that — I can only give this fund two thumbs up.
Xtrackers (Deutsche Bank) S&P SmallCap 600 ESG ETF (SMLE)
Inception date: February 24, 2021
Management fee: 0.15 percent
Investment focus: This is a passively managed fund tracking the S&P SmallCap ESG Index.
ESG strategy: The fund excludes companies it deems nasty in terms of ESG, using criteria set up by the United Nations. Companies are ranked within their industry groups, with the aim of investing primarily in those companies acting most sustainably.
Russell’s review: There are many, many more large-cap stock offerings among ESG funds than there are small-cap funds. At last count, only seven percent of U.S. equity funds with a sustainability focus were invested primarily in small-cap stocks. This is something of a head-scratcher to me, but in the end, you just don’t have all that many choices. Yet every portfolio deserves some small cap. This fund, with its reasonable expense ratio, is certainly a good option.
Nuveen ESG International Developed Markets Equity (NUDM) and Nuveen ESG Emerging Markets Equity (NUEM)
Inception date: June 5, 2017
Management fee: 0.40 percent for NUDM; 0.45 percent for NUEM
Investment focus: These are both passively managed funds tracking the TIAA ESG International Developed Markets Equity Index and the TIAA ESG Emerging Markets Equity Index, respectively. The top five countries in the Developed Markets ETF are Japan, the United Kingdom, France, Switzerland, and Germany. The top five in the Emerging Markets ETF are China, Taiwan, the Republic of Korea, India, and Brazil.
ESG strategy: The managers screen out the bad and overweight the good using the indexer’s ESG valuations that select the best companies in each industry sector.
Russell’s review: These are a bit pricey for index funds, if you ask me, but not crazy expensive. The indexes are solid, although I’d be a bit concerned that the emerging-markets fund features nearly 40 percent China. The ESG screening is reasonable, and the company does a good job of voting yay on environmental proxy measures.
Humankind U.S. Stock ETF (HKND)
Inception date: February 24, 2021
Management fee: 0.11 percent
Investment focus: This fund is run to track Humankind’s own index, which they call the Humankind U.S. Equity Index. It scans the U.S. stock market and pulls out those companies doing good for the world, then applies some market weighting. The fund has 998 companies in its portfolio, the largest holdings being Alphabet, Verizon, Corteva (seeds, and crop protection products with an eye toward sustainability), Microsoft, and Apple. The portfolio is a total market fund, but because of the cap weighting, you’ll get more exposure to large-cap stocks than anything else. With a P/E ratio of 20.5, HKND is quite value-y.
ESG strategy: This firm, which issues only one ETF, is all about ESG. Management is very critical of its competition’s tendency to use a “best in class” rating system to choose securities. “If the investing philosophy of choosing the least-bad corporate actor per industry were around in the 1700s, it could have supported the ‘best’ slave trading company,” says Humankind on their webpage. The fund (obviously) does not screen within industries, but looks to the market as a whole to invest in the companies making the biggest positive impact on the world. They then try to get actively involved to make good world citizens great world citizens.
Russell’s review: I have little doubt as to Humankind’s devotion to ESG. And the fees they are charging investors are very reasonable. (Less, in fact, than many other total-stock-market ETFs.) The fund has a short track record, but given the size of the portfolio — 1,000 firms — it seems unlikely to me that the long-term performance of this fund will differ all that much from the market at large, and if it does, it will probably outperform, simply given its value tilt. My main concern would be with the viability of the young company itself and whether this fund may potentially close. But keep in mind that when ETFs close, investors get back whatever the firm’s holdings are worth at the time of the ETF’s demise. So the main cost would be the hassle of paperwork, and possibly a capital gains hit at an importune moment.
VanEck Vectors Green Bond (GRNB)
Inception date: March 3, 2017
Management fee: 0.20 percent
Investment focus: Intermediate-term bonds issued by global institutions and various nations from every continent (well, except Antarctica). The top five countries are the U.S., China, India, South Korea, and Germany. The vast majority are investment-grade bonds with an average credit quality of A. This fund is passively run, with a current yield of 1.8 percent.
ESG strategy: The fund tracks the S&P Green Bond U.S. Dollar Select Index, comprised of U.S. dollar-denominated “green bonds.” They are so called not because they are denominated in greenbacks but because they were issued to finance environmentally friendly projects.
Russell’s review: It has been argued that ESG investing can have more impact when the investing is done in bonds rather than stocks. Why? Because a fund manager will usually buy bonds directly from the issuers, rather than, like stocks, on the open market from a third party. Some ESG bond funds, like ESG stock funds, go through a screening process and try to eliminate companies that put profits above people. But green bond funds are different in that they invest specifically in bonds used to raise money for worthwhile projects, to build solar panels, create geothermal energy, recycle waste, make buildings more energy efficient, preserve wetlands, distribute water to areas of drought…you get the idea. There are several green bond ETFs. I like VanEck’s because of the low cost ratio and the broad diversification.
KraneShares Global Carbon ETF
Inception date: July 30, 2020
Management fee: 0.79 percent
Investment focus: With this unique ETF, you’d be entering the global cap-and-trade carbon allowance market, buying up futures contracts on carbon offsets (kind of like get-out-of-jail-free cards for polluters). You’d think, logically, that with the worsening of global warming, prices of these carbon offsets would increase as governments tighten regulations. In addition to this price growth potential, carbon offset valuations seem unrelated to the price of stocks or bonds, making this investment a potentially potent hedge.
ESG strategy: The higher the demand for these carbon allowances, the more the price will be jacked up. The more the price is jacked up, the more companies will need to pay to emit greenhouse gases, and the more incentive they will have not to.
Russell’s review: You could stand to profit, and those profits could do the world some good. But there’s plenty of risk here. A revolution in manufacturing technology, for example, could do away with the need for the carbon offsets. Future administrations that take an unsympathetic view of regulations could also drive a spike into the heart of carbon cap and trade. If you don’t mind the risk, go for the return. But I wouldn’t suggest a portfolio position of more than five percent.