4 ETFs From Across the ESG Spectrum

Christine Benz: Hi, I'm Christine Benz from morningstar.com. The universe of exchange-traded funds that focus on ESG, or environmental, social, governance issues, is rapidly expanding. Joining me to discuss some of the key ETF types currently available is Alex Bryan. He's Morningstar's director of passive strategies research in North America for Morningstar research services.

Alex, thanks for being here.

Alex Bryan: Thank you for having me.

Benz: Before we get into the specifics of various ETFs pursuing ESG strategies, let's look at how Morningstar approaches rating ESG funds. So the Analyst Ratings don't attempt to evaluate how funds are doing in terms of their ESG factors. Do they?

Bryan: That's correct. So we treat our Morningstar Analyst Ratings for ESG funds the same that we do any other fund, which is based on our forward-looking assessment of how well that fund is going to do in terms of risk and return relative to its category peers. So we're not making a subjective assessment of whether or not we think the fund is delivering on its ESG mandates. For that, the Morningstar Sustainability Rating, which is powered by data from Sustainalytics, that might be more relevant to try to gauge that. But the Analyst Ratings are really strictly focusing on risk and return on a go-forward basis.

Benz: Historically one of the biggest knocks against ESG investing is that these strategies were often more costly than non-ESG strategies. With the strong uptake in entrance of ETFs and index funds focusing on ESG matters, is that changing?

Bryan: It is. You know, historically a lot of ESG index funds were quite a bit more expensive than the lowest-cost non-ESG-focused index funds. Today, there are a lot of low-cost ESG options. Some charges as low as 10 basis points. That's still a little bit more than the lowest-cost passive funds out there, but it's pretty close, and I think fees always matter, but there is an ever-expanding menu of low-cost ESG options. So I don't think cost is really a big hurdle anymore for investors who care about some of these social issues.

Benz: You focus the upcoming issue of Morningstar ETFInvestor on the ESG universe, and you say that it really runs the gamut. So let's take a spin through some of these different ETF types that are available, starting with the original ESG strategies, which were very much about excluding companies in objectionable industries. What's an example of an ESG ETF with that old-school type of exclusionary strategy?

Bryan: I think Vanguard ESG US Stock ETF is a really good example of this type of fund, which is what I consider to be a values-based exclusion approach to investing. This fund tries to provide very broad exposure to the U.S. stock market, but it excludes stocks that are involved in certain lines of businesses that some investors might find controversial. So, for example, this fund excludes all firms that drive a large part of their revenue from the sale of fossil fuels. It avoids companies involved in the production and distribution of alcohol, firearms, gambling, tobacco, things like that. But the active share of this fund is actually quite low. So it's actually providing very broad exposure to the market, covering between 70% to 80% of the U.S. market. But it does exclude some of those types of companies that some investors might find objectionable. As a result of those exclusions, what you end up getting is a fund that has some modest sector tilts relative to the broad market. So this tends to be underweight energy, overweight technology as you might expect. But it's really designed to try to effectively diversify risk while avoiding some of those controversial businesses that some investors might find objectionable.

Benz: ESG offerings have increasingly evolved beyond just excluding companies and instead use positive screens to identify companies that are managing ESG risks. So, what's an example of a fund with a strategy along those lines?

Bryan: Ishares ESG MSCI USA Leaders ETF, I think, is a really good example of this type of fund that's looking beyond just excluding certain types of businesses to look for firms that are exemplary in terms of how they deal with their ESG risk and opportunities that are relevant for their particular industries. This particular fund targets stocks that are really leaders in their industry. It's looking for firms that are taking steps to mitigate the risks that might be most relevant to them. So, for example, within the banking sector, it might look for stocks that are taking steps to manage data security and doing a really good job of that. Within the consumer products industries, it might be looking at how firms are packaging their goods to make sure that they're doing that in a sustainable way. So the characteristics that it's looking for are really industry-relative and they're most relevant for each industry. But I think this is a really good example of the fund that's really going after those leaders. It ends up taking a bit more active risk than that Vanguard fund because it's setting a higher bar for inclusion. But if you are someone who does care about these issues, I think this is a really good strategy that tries to put ESG first ahead of mitigating tracking error.

Benz: You mentioned active risk. Alex, let's talk about what that is, and can you give us an example of a fund that does try to control for that active risk while pursuing an ESG strategy?

Bryan: Active risk is really any bet that you're making relative to the markets, and the types of active risks that you need to be concerned about are the types of risks that you may not necessarily target or that you don't necessarily want. So if you're an ESG-focused investor, clearly you want to own firms that are managing their ESG risks better than others, but sometimes along with those ESG screens, you end up getting these ancillary bets. So, for example, a lot of ESG funds tend to be structurally underweight energy stocks, and they tend to be structurally overweight technology stocks. And that can be a source of risk that can--sometimes it pays off and helps your performance; sometimes it may actually hurt your performance. There's really this trade-off between mitigating active risk and really owning the very best ESG firms out there. The more you reach for ESG leaders, the more your risk of underperforming the market might be or outperforming the market. You definitely have a greater risk of having a performance stream that looks quite different from the market. And so there's some ESG-minded funds out there that tried to balance ESG against mitigating tracking error to the broader market. So effectively helping you target the type of risk that you want, which is exposure to ESG leaders, while still maintaining broad diversification so that you're not really banking on a few individual companies or a few individual sectors.

So a fund that I think strikes this balance quite well is the iShares ESG MSEI USA ETF. It's a mouthful, but this fund basically measures ESG leaders in the same way that the sustainable ETF does. The only difference here is that this actively tries to mitigate tracking error to the broader market. So it's effectively constraining the portfolio to keep the sector weightings in line, to keep the risk in line with the broader market. So if you're looking to have something that could serve as a core fund but still lean into some of the ESG leaders in the market, I think this is a really good option.

Benz: Finally, let's take a look at an ETF that takes a more proactive approach to ESG issues.

Bryan: Ishares Global Impact ETF is a really good option for investors that want to do more than just own firms that are managing their social practices in a favorable way, looking for firms that are actually producing goods and services designed to address one of the world's major social or environmental challenges like hunger, education, clean water, global healthcare. This is a bit more of a compact portfolio that invests in firms like Tesla, a lot of healthcare companies like Johnson and Johnson. It may be more appealing for investors that are looking to invest in companies that are changing the world for the better.

Benz: Alex, it's always great to get your perspective. Thank you so much for being here.

Bryan: Thank you for having me.

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

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