Vanguard ESG International Stock ETF Makes Few Compromises

Environmental, social, and governance strategies can help investors align their investments with their values. But they are still subject to the same forces that drive long-term performance in their non-ESG counterparts. Great ESG strategies diversify their risks and keep fees low. Vanguard ESG International Stock ETF VSGX eliminates stocks that score poorly on several ESG-related metrics without sacrificing the benefits of broad diversification. Its expansive portfolio and low expense ratio earn the fund a Morningstar Analyst Rating of Gold.

The fund tracks the FTSE Global Ex US Choice Index. This broad benchmark starts with all stocks in the FTSE Global All Cap Ex US Index. It excludes those with close ties to fossil fuels, vice products and services, and weapons. It uses additional screens to remove companies with poor conduct related to the environment, human rights, labor, and diversity.

These exclusions cause the portfolio to deviate from its parent universe in a few ways. As of March 2020, it excluded about 30% of the stocks (by count) from its parent universe. It has consistently underweighted stocks from the energy sector because of their direct involvement with fossil fuels. Other examples of exclusions include Diageo DEO and British American Tobacco BTI, which fail to make the cut because they make alcohol and tobacco-related products, respectively.

Despite these differences, the fund’s target index still captures 75% of the parent universe’s market capitalization, and it remains well diversified. The portfolio holds more than 4,000 stocks, and its 10 largest names represent only 14% of the portfolio. Energy stocks aside, its remaining sector and country weights hew close to those of the broader foreign stock market.

This is a relatively new fund, so it has a limited track record. During its short life, its lower allocation to energy stocks helped it outperform many of its competitors. It beat a typical peer in the foreign large-blend Morningstar Category by 1.7 percentage points annually from its launch in September 2018 through March 2020. The fund’s low 0.17% expense ratio should provide a long-term edge.

Process This fund's target index uses exclusionary screens to eliminate companies that score poorly on several ESG-related metrics. It maintains a high level of diversification and reasonably represents the broader foreign stock market in a cost-effective way, earning a High Process Pillar rating.

Vanguard's portfolio managers use a sampling process to track the FTSE Global All Cap Ex USA Choice Index. This bogy includes stocks of all sizes from the FTSE Global All Cap Ex USA Index--a broad benchmark that covers foreign developed and emerging markets. It excludes companies with close ties to fossil fuels and nuclear power, vice products (alcohol, tobacco, gambling, and adult entertainment), and weapons. It applies additional screens to remove companies with poor conduct related to the environment, human rights, labor, and diversity. The final index weights stocks by their free float-adjusted market capitalization. This approach benefits investors by reining in turnover and the associated trading costs.

This strategy does not have strong corporate governance screens. It requires companies have two of the following three items in place: diversity policies, a diversity management system, or at least one female on the board. The index does not screen for other governance-related characteristics, like board member independence.

This strategy effectively eliminates stocks that score poorly on its targeted ESG metrics. But excluding names with the lowest ESG scores while maintaining a broad portfolio can water down the fund’s overall exposure to stocks with relatively stronger scores. Its historical sustainability score, which incorporates ESG-related metrics, is only slightly better than the average fund in the foreign large-blend category.

The benefit of this exclusionary approach is that the strategy’s extensive reach sweeps more than 4,000 stocks into its portfolio, making it one of the most diversified funds in the category. Its 10 largest positions account for only 14% of assets. Outside of energy stocks, many of its largest constituents overlap with those in its parent universe, the FTSE Global All Cap Ex US Index.

Excluding companies with ties to nonrenewable energy means the portfolio has consistently underweighted the energy sector relative to its parent universe. As of March 2020, the fund’s allocation to energy stocks was about 5 percentage points lower than the FTSE Global All Cap Ex US Index. It makes up for this difference by modestly overweighting stocks from the financial sector. Aside from those differences, the fund’s country and sector weights closely match those of the broader foreign stock market.

Performance This fund has a short track record, but it did manage to outperform the category average by 1.7 percentage points annually from its launch in September 2018 through March 2020. Most of that excess return came from underweighting poorly performing energy stocks. Stock selection in the communication, consumer staples, and industrial sectors also helped its total return. But these short-term benefits shouldn't be interpreted as reliable sources of outperformance.

Excluding poor ESG-scoring stocks means the strategy’s performance will deviate from its parent universe, the FTSE Global All Cap Ex U.S. Index. Its target index had a tracking error of about 1.4 percentage points over the five years through March 2020.

People The portfolio managers on this fund are part of Vanguard's Equity Index Group. This wider team has a global footprint and uses the latest in portfolio management technology to track the fund's target index. They earn an Above Average People Pillar rating.

Christine Franquin and Scott Geiger share responsibility for this fund. Franquin is a principal at Vanguard while Geiger is a portfolio manager. Both have over a decade of experience at Vanguard and help captain some of the firm’s largest index-tracking funds listed in North America.

This duo not only oversees the portfolio but also executes trades on a day-to-day basis. Vanguard typically rotates portfolio managers around from one fund to another every few years to improve their breadth and depth of expertise. They also have access to Vanguard’s global trading desks, enabling them to make the most cost-efficient transactions in various global markets.

Vanguard’s portfolio managers are compensated with a bonus that factors in the gross, pretax performance of the fund relative to its objectives. This includes the manager’s record of tracking a benchmark index over the prior 12 months. These characteristics align the interests of the managers and investors.