Environmental, Social and Governance (ESG) continues to grow rapidly as an investing theme. Each individual investor likely has a unique opinion about which ESG criteria are the most important. For some, it may be avoiding oil companies or heavy polluters, while others may want to emphasize factors like labor rights or board diversity.
Likewise, the definition of ESG used by fund managers in screening their investments may differ materially from firm to firm. For example, which specific ESG criteria does the fund utilize when defining a “good” company relative to a “bad” company in the E, S and G buckets? And how are those criteria weighted when determining that company’s overall ESG score or rating? Further, how often are companies re-evaluated?
Another issue arises in how a fund chooses to reflect those outcomes in its portfolio. For example, will investments in oil companies or defense contractors be excluded entirely, or will the fund have some exposure to every sector and then try to pick the least offensive companies in each?
Because diversified funds have exposure to hundreds, if not thousands, of individual companies, it is probably unrealistic to expect that any fund will exclude every company that a given investor wants to avoid. Thus, it can be difficult for an investor to know which fund option to choose in order to most closely match their desired outcomes. Adding to the complexity is the proliferation of new ESG-tilted investment products and the fact that fund holdings may change over time.
Relative to the above, investors for whom climate change and environmental stewardship are critical issues would likely want to understand how well the available funds reflect those biases. We recently examined seven of the largest ESG-labeled U.S. stock exchange-traded funds (ETFs) to see what type of exposure each had to fossil fuels and carbon emissions.
The ETFs were screened based upon their size (assets under management of at least $1 billion), their cost (fees of 0.4% or lower), and for having an ESG investment mandate covering the broad U.S. large cap stock market1. They included:
The path of climate change will largely be determined by two factors. One is the level of current emissions. Carbon Intensity is defined as emissions (in tons of CO2 equivalents) per million dollars in revenue. It provides a way to measure a company’s current contribution to emissions, adjusted for the company’s size.
The second factor is the level of future emissions, which will be driven by how much of the planet’s untapped fossil fuel reserves will ultimately be burned. Companies that own fossil fuel reserves are more likely to contribute to future climate change.
For an investment fund, it is possible to calculate fund-level Carbon Intensity by taking the weighted average of the underlying companies owned by the fund. Likewise, it is possible to calculate the percentage of the fund’s assets represented by companies that own fossil fuel reserves.
For the seven ESG ETFs we examined, weighted average Carbon Intensity ranged from 59 (ESGV) to 137 (SPYX). To put this in perspective, Vanguard’s S&P 500 ETF (VOO), which we use as a proxy for the broad U.S. large cap stock market, had a Carbon Intensity metric of 154. Thus, all of the ESG funds posted a lower current emissions profile than the market proxy. Five of the seven funds were lower than the benchmark by 50-60%, representing a material reduction. SPYX represented the lowest reduction at about 11%.
While the Energy sector has become smaller as a portion of the overall global stock market over time, it is worth noting that the fossil fuel reserves held by the 200 largest publicly-traded owners are sufficient to produce almost 700 gigatons of future CO2 emissions4. Exposure to companies that own fossil fuel reserves ranged from 0.2% (ESGV) to 4.8% (ESGU). By comparison, VOO had exposure of 6.5%. Thus, all of the ESG funds achieved lower fossil fuel exposure than the broad market, although three of the seven had more than 1% of their assets invested in companies that own fossil fuel reserves. Whether that level of exposure is low enough would be subject to each individual investor’s tolerance.
The market sectors most exposed to climate change are Energy, Utilities, Materials, and Industrials. Companies in the Energy sector own substantial unburned fossil fuel reserves, and these four sectors are also the largest in terms of current carbon emissions6. These sectors represent approximately 17.9% of the S&P 500 index, as measured by VOO.
We looked at the ESG ETFs to determine what portion of each fund’s assets are invested in these four sectors. Two of the funds actually had more exposure to these sectors than VOO, and four others were within about 4% of VOO’s total. Only ESGV had a substantially lower exposure to these sectors at 8.8%.
Finally, we sought to determine whether the underlying holdings of these funds included specific companies that might be undesirable to a climate-focused investor. We first looked at Vanguard's Energy sector ETF (VDE) and identified its 20 largest holdings as a proxy for major energy companies in the U.S. We then examined each of the ESG ETFs to see how many of those 20 companies were held in each fund and what percentage of the fund's assets they represented in total.
Six of the seven ETFs had some exposure to these companies. Three of the funds owned 10 or more of the 20 companies. The percentage of fund assets represented by these companies ranged from 0.00% (ESGV) to 4.18% (ESGU).
ESGU in particular is worth noting. This fund is the largest U.S. ESG equity ETF by far, with over $22 billion in assets. Yet, an investor who owns ESGU actually has about the same percentage exposure to these 20 energy companies than an investor who simply buys Vanguard’s S&P 500 ETF (4.18% in ESGU versus 4.24% in VOO). Among the holdings in ESGU are ExxonMobil, Chevron, ConocoPhillips, Schlumberger, and Marathon Petroleum.
This relatively simple examination underscores some important considerations for investors when evaluating ESG-labeled products.
First, the definition of ESG varies across providers, which can lead to material differences across funds. Many ESG decisions are also somewhat subjective. For example, one fund’s definition of undesirable labor practices may differ from another’s.
A related conundrum faced by fund managers is how to consider environmental, social and governance criteria while still building a diversified portfolio. While managers may be able to achieve some improvement in all three of those areas relative to a broad market index, the degree of improvement may feel somewhat underwhelming to an ESG investor who is focused on a particular area such as climate change. By seeking to satisfy so many disparate ESG criteria, managers may only achieve relative mediocrity across all of them.
Further, an ESG label should not be taken at face value as an indication that certain types of investments are excluded. Investors who want to ensure that their capital is being allocated toward the issues they care about most should understand which funds provide that alignment.
The above issues drive One Day In July’s decision to emphasize environmental criteria. Carbon Intensity and fossil fuel exposure are more objectively measurable and less open to individual interpretation. By narrowing the scope, we also seek to achieve excellence in the environmental area rather than relative mediocrity across many planes.
This approach helps us cut through much of the opaqueness associated with ESG products. It is no accident that of the seven ETFs we examined, only ESGV has occupied a significant place in our clients’ environmental portfolios. In the above analysis, it consistently showed superior metrics around climate change criteria than the other funds. We supplement our holdings in ESGV with a number of other funds evaluated in a similar way across other parts of the market, such as small cap stocks and real estate, among others. We also continually re-evaluate the universe of available funds to account for positive or negative changes in a fund’s profile and to account for newly available products.
For clients who are focused on climate change, we believe this approach provides a transparent and simple way to determine alignment.
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1. These screens help to ensure that ESG benefits are not being achieved at the expense of higher fees or worse liquidity. There are many new and potentially promising ESG products that have been rolled out recently, and we are hopeful that the universe of funds that meet our screens will continue to expand. It should also be noted that this analysis was limited to ETFs and did not include mutual funds. This was done to reflect our belief that ETFs are generally more cost-effective than comparable mutual funds
2. Each fund’s assets under management and current fee rate were evaluated based on the fund provider’s most recently published data at the time of analysis. For each of the seven funds, this was as of either July 27, 2022 or July 28, 2022.
3. Carbon Intensity and ownership of fossil fuel reserves for each ETF in this section were based upon the most current available data from MSCI, Inc. accessed through ETFdb.com. Data sourced as of July 31, 2022.
4. Fossil Free Indexes.com, December 31, 2021.
5. Sector exposure for each fund in this section was sourced from Charles Schwab & Co. Data is as of June 30, 2022.
6. This was determined by obtaining a Carbon Intensity metric for each of Vanguard’s sector-specific ETF offerings. These ETFs collectively cover all of the major sectors contained in the S&P 500 index.
7. Each fund’s holdings were evaluated based on the fund provider’s most recently published data at the time of analysis. For VDE and VOO, this was as of June 30, 2020. For all other funds, it was as of July 27, 2022 or July 28, 2022.