2 Best-of-Breed ESG ETFs

Christine Benz: Hi, I'm Christine Benz for Morningstar. Funds with environmental, social, and governance mandates have been growing quickly, and ESG index funds have been growing particularly quickly. Joining me to discuss that group is Alex Bryan. He's Morningstar's director of Passive Strategies Research for North America.

Alex, thank you for being here.

Alex Bryan: Thank you for having me.

Benz: So, Alex, you and the team recently put together an extensive white paper on this topic of ESG index funds. You talked about the main subsets of ESG index funds. Let's talk about them, how you group these different products?

Bryan: So, there's three broad groups that we look at. The first is exclusions ESG funds. These are basically where sustainable investing started. These funds generally provide broad exposure to the market and then exclude firms that are in either controversial lines of business like alcohol, tobacco, firearms, fossil fuels, things like that, or that are involved in controversies like Wells Fargo was a few years back with their fraudulent account scandal, or Volkswagen with their emissions scandal. But otherwise they provide broad exposure to the market.

Broad ESG is the second group that we think about. These go one step further. So, a lot of times, these have these similar types of exclusions. But then they also have screens in place to tilt toward firms that have really strong environmental, social, and governance practices, what we call ESG. The focus of a lot of these funds is on how firms operate rather than on the products they produce. So, for example, a firm like Tesla, which makes a very environmentally friendly product, may not always score well on the ESG criteria these types of funds look at.

And then, the last group of sustainable funds that we look at is what we call thematic funds. These are funds that are more narrow, and they often focus on one issue related to sustainability. So, it could be things like gender diversity, carbon footprint, alternative energy, and these funds are designed to be used more as satellite holdings.

Benz: Okay. So, when you look across this universe, the ESG group has been growing really quickly in terms of number of funds and in terms of assets, where have you seen the most asset growth across these three different subgroups?

Bryan: Broad ESG funds have really attracted the lion's share of assets--in particular, broad ESG equity funds. So, really, investors are looking for core portfolio solutions to serve as substitutes for traditional index and active products. So, that's where we've seen the bulk of the assets go. There are a fair bit of assets going into exclusionary funds as well, and a lot fewer going into the more niche thematic products. But broad ESG is where most of the action has been.

Benz: Okay. So, there has been fairly substantial asset growth. Why do you think there hasn't been an even greater adoption of ESG products in the U.S.?

Bryan: Well, the U.S. is behind other markets like Europe in terms of adoption and I think part of that is due to this perception, at least historically--there's been a perception that by focusing on sustainability issues, you have to sacrifice performance in some way. Morningstar's quant research team actually did some work on this using Sustainalytics' data and found that there really isn't much of a relationship, positive or negative, between sustainability and performance. And so, I think that story is starting to change where investors are realizing that there isn't necessarily a trade-off, so they can focus on the things that are important to them and still do okay on the performance front. So, I think that story is starting to change and that's helping to drive greater adoption, but still there's this perception that's persistent in certain corners of the market.

There's a couple of other issues at play as well. I think a lot of investors are concerned about alignment between the values that they care about and the portfolios that they're getting. Sometimes different ESG ratings between different providers can be very different for the same firm. So, there I think is some concern that maybe I have an idea about the issues that I care about, but the portfolio that's being marketed to me as ESG may not necessarily align with the specific values that I care about. And so, there's a lot of work that investors have to do to make sure that what they're investing in does in fact align.

And then, lastly, I think there's this debate out there about whether it's better to exclude ESG laggards--so the firms that are considered “bad actors,” so to speak--or if it's better to just own them in a broadly diversified index fund and then use things like proxy voting and engagement to prod those companies to change their ways. There's a debate on this issue, and I think that hasn't been resolved quite yet. But performance and perceptions around that I think have been the biggest obstacle to greater adoption. But that story is certainly starting to change.

Benz: So, when you look across the universe of ESG index funds and ETFs to-date, are there any funds or suites of funds that stand out as being really exceptional at this point?

Bryan: So, there's a couple of low-cost funds that I like. So, on the exclusionary front, if you want to keep it really simple and really broad, one fund to consider would be the Vanguard ESG US Stock ETF ESGV. This is a fund that basically provides broad exposure to U.S. stocks of all sizes, but it does exclude firms that are engaged in certain lines of businesses like fossil fuels, firearms, tobacco, alcohol, as well as firms that are engaged in significant controversies. So, it's just excluding a few of those controversial firms and then otherwise providing very broad exposure to the market weighting its holdings based on market capitalization and it's keeping fees low. So, everything that we like about traditional index funds, we like about this fund. And if you do care about avoiding some of those potentially controversial companies, this would be a good option to consider.

If you're looking to go a step further and really key in on those ESG leaders, the best of breed, a fund that we like there is iShares Edge MSCI USA Leaders ETF SUSL. This particular fund has similar types of exclusions to the Vanguard fund. But then, it basically ranks companies within each sector on sustainability issues that could be material to financial performance long-term. So, for example, in the financial-services industry, it's looking at things like data security, how well are firms doing there; in consumer products, it's looking at things like packaging, how environmentally responsible are those companies being. So, it's looking at the issues that relate to sustainability that could be financially material, and essentially, it's targeting the better-ranking half of firms in each sector. So, its sector weightings are very similar to the overall market. It does own some energy stocks, which may be a deal breaker for some, but otherwise it's looking for best of breed within each sector. It also is a very low-cost fund. So, it's one that we like.

Benz: Okay, Alex, really interesting topic. Thank you so much for being here to discuss it with us.

Bryan: Thank you for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.

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