Friday, May 14

ESG index funds are hot. That may be a risky thing for investors

Mason Trinca | Getty Images News | Getty Images

Google employees at the tech giant’s headquarters in Mountain View, California, walk off the job to protest the company’s handling of sexual misconduct claims.

When it comes to investing, the notion that you can make money in the market and feel good about your investments at the same time is very compelling, especially among younger investors from the millennial and Gen Z demographics. This is the key reason why environmental, social and governance (ESG) screens are being more commonly used to evaluate stocks by fund managers — including the world’s biggest of all, BlackRock — and socially responsible investing is attracting more assets.

According to Morningstar, estimated flows into open-end and exchange-traded sustainable funds, the overall category of ESG and SRI funds, reached $13.5 billion through this past September. That’s not a huge number relative to the overall size of the fund industry — which is measured in the trillions of dollars — nor is it big compared to overall ETF flows, which have reached hundreds of billions of dollars annually in recent years. But it is a big jump from the $5.5 billion these funds attracted in all of 2018.

One short-term reason for increased interest: the year-to-date performance of many of these funds has been strong.

The Vanguard ESG U.S. Stock ETF is up over 27% year to date, through Nov. 13, according to Morningstar data, and that’s compared to an S&P 500 ETF return of over 25% —.a 2% performance edge for Vanguard. BlackRock’s iShares ESG MSCI USA ETF is up 25% year-to-date, matching the market. Why would the performance edge exist for the Vanguard ETF and some other ESG funds showing recent outperformance of the S&P 500? To answer the question, you have to look under the ETF’s hood.

The Vanguard ESG ETF has a 28% sector weighting to technology, which is significantly higher than the S&P 500 and iShares ESG fund’s roughly 20% weighting to technology stocks. The “large-blend” category that Morningstar puts these funds in has a 22% weighting to tech, on average. For investors in ESG funds where a tech weighting is higher than average, it’s an advantage right now but could be a bigger risk for investors than they appreciate.

I want to make one thing clear: I am pro-environment, pro-equal rights for women and minorities, and pro-LGBT rights. I don’t hunt, my wife won’t wear fur, and we would never buy a backyard set made with redwood. I am not against the socially responsible investing approach and I’ve told clients that if owning ESG funds is the only way you’ll stay invested, then it’s not a bad way to go. But as a fiduciary, it is important for me to be clear with investors about what they are buying.

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