ESG Metrics and the Average Investor

Only a few years ago, finding an environmentally and socially conscious fund to easily invest in was nearly impossible. Back in 2014 and early 2015 I rooted around looking for an investment management company, preferably something low cost that I could do online, that focused only on investing in companies that were pushing forward the progress of protecting our environment.

At the time, I was working for a company that was a leader in what many see as one of the dirtiest businesses out there: Canadian oil sands. Environmental and social sustainability were always at the top of my mind, and I was motivated to squirrel away some excess cash in a way that could make a difference, especially if my day to day job wasn’t doing any good on that front. I remember coming across one company that offered a fund, however it seemed expensive and did not seem transparent enough for me to feel confident pursuing it. There may have been others out there but they were very difficult to find.

Today, with the rise of passive, index investing, there are many ETFs that seem to account for the ESG (environmental, social, and governance) features that companies have now realized are of value to younger investors. Today, investors can open the Robinhood app and trade over 75 different ESG ETFs in seconds; they can sign into Vanguard, Fidelity or other investment accounts and buy some of those same ESG ETFs, just as you would a stock. And then there are companies like Swell Investing, which has built its own funds that do not follow the indices compiled by third-party firms like MSCI, but also require opening an account with them in order to invest.

There are two main types of ESG fund. The first recognizes environmental, social, and governance risks and builds a portfolio of companies intended to minimized the fund’s exposure to those risks. The second is structured more like a typical ETF, but excludes companies in certain industries. With so many options out there for putting our money where our beliefs lie, what should the average impact-seeking investor do? Number one: Read about what you’re buying. To explain why, I will tell an anecdote about Vanguard’s recently introduced ESG U.S. Stock ETF (ESGV).

ESG ETF principle misalignment

These two recently introduced funds are managed by Vanguard itself and follow an FTSE index. Upon learning about these new funds back in October, I opened up the Vanguard site that outlines all of the information you could want about the fund. The first things I noticed were that the fund tracks the FTSE US All Cap Choice Index and it is “[s]creened for certain environmental, social, and corporate governance (ESG) criteria.” The last thing to catch my attention was this:

• Specifically excludes stocks of companies in the following industries: adult entertainment, alcohol and tobacco, weapons, fossil fuels, gambling, and nuclear power.

This all sounds like something that would be attractive to many potential investors seeking to integrate ESG values into their portfolios. But before you make a move, it’s important to still look at what companies this ETF holds.¹ This is where, in my view, the problems begin.

First of all, when I see that the fund is excluding stocks in the fossil fuel industry, I presume that they are doing that. One of the things I noticed immediately in skimming through the more than 1,400 holdings was that Schlumberger was on the list. Schlumberger is a massive exploration and oilfield services firm, which, going by their 2017 10-K, derives the vast majority of their revenues from exploration activity. Further down the list I found Marathon and Valero, which are household names that deal very heavily in the oil and gas sector, refining specifically. Kinder Morgan was also there, which builds, owns, and operates fossil fuel pumping and pipelines throughout the country. There were other oddities, but I will stop there.

I reached out to the individuals listed as the fund managers to ask about this. I certainly see that there are many arguments one could make for where to draw the line of what constitutes a company that operates in the fossil fuel industry. Including a company that uses feedstocks derived from fossil fuels to make a product many steps removed from the oil coming from the ground seems like it might be OK. Maybe it would also be acceptable to include a company that relies heavily on petroleum derived products, but also has a very highly regarded sustainability program (i.e. DowDupont). But my question was not about that. It was about a handful of companies that seem to directly go against the claim of excluding stocks in the fossil fuel industry.

The response I got from Vanguard did not quell my concerns. Schlumberger derives its value from drilling for oil, a fossil fuel. Yet Vanguard’s response (via an “Executive Correspondent”) regarding this point was as follows:

“The FTSE US All Cap Choice Index does not include stocks of companies involved in the production of adult entertainment, alcohol and tobacco, weapons, fossil fuels, gambling, nor nuclear power. More specifically, with regard to fossil fuels, the index excludes companies that extract non-renewable energy sources such as oil, natural gas, and coal, yet it does not exclude companies that solely refine and/or distribute fossil fuels. Please know that although it is entirely reasonable for you to have a differing opinion as to what meets the above conditions, Vanguard is obligated to track the ETF’s underlying target benchmark which is developed and maintained by an independent, third-party company.”

Vanguard must certainly track the underlying benchmark that it has chosen, since that’s what ETFs are intended to do, but was that benchmark the right choice? Is that benchmark what it is advertised to be? I believe this fund may mislead investors who do not:

1. Take the time to investigate the 1,400-company list (a pretty ridiculous task, to be honest), and
2. Recognize firms that are outside of their immediate sphere of knowledge.

I just happened to know what Schlumberger is and does; many individuals without a background in the US energy industry might not.

Going beyond the fact that Schlumberger is “involved in the production of…fossil fuels” and should thus be excluded, one could also argue that firms that “solely refine and/or distribute fossil fuels” derive their value from the fossil fuels they refine and distribute. Assuming these companies continue status quo operation, if fossil fuels went away, so would they. So owning this ETF would not eliminate my exposure to fossil fuels as much as I would have thought, given the fund’s description. Similarly, the fund benefits, to some degree, from the success of the fossil fuel industry, as it manifests itself through Schlumberger’s and others’ operating efficiencies and increased revenues, which fossil fuel demand drives. The moral of the story here is that many companies included in these “ESG” ETFs might not necessarily be better than what you would find in your average mutual or index fund, and it’s worth looking into before purchasing. My next post does suggest that Vanguard’s ESGV fund may be an anomaly, and that other ESG funds are more explicit in their principles, and it is reflected in their holdings.

Composition is important

My next post dives deeper into what comprises ESG ETFs and how they are designed, but at a high level, if we look at some of the top 10 holdings of many ESG ETFs, we find that they look very similar: Microsoft, Apple, Facebook, Amazon, Alphabet. These are companies that have certainly been driving demand for things like renewable energy and improved social accountability in various ways. With some governments taking a back seat, companies have decided to drive forward the push for 100% renewable energy goals. Due to their ubiquitous nature and wide public exposure, these companies must operate in a manner that anyone analyzing their social governance would find acceptable. Because of these two points, I wonder if it is not so much about who is doing good, as it is about who is not doing bad.

To summarize, it is important to look at the composition of the ESG ETFs on offer before deciding to buy. Many of the companies that are weighted heavily in these ETFs are also weighted heavily in things like an S&P 500 Index ETF. Thus buying into an ESG ETF may not markedly change your overall portfolio if you also hold funds that invest heavily in Apple, Amazon, etc. And what good does funneling our savings into these ESG ETFs really do? Are we really pushing the frontier forward by investing in public companies that already appear to have the right goals in place? One could argue yes, since we as consumers may want to reward those companies for making those environmental and social responsibilities a priority, but can we do more?

Alternative options

The idea behind Swell Investing’s products seems to be more in line with what the truly conscious investor might want. For its funds, Swell selects firms that are pushing areas like clean water and disease eradication forward. Since the average investor cannot easily invest in private firms, it seems that Swell Investing, (or, as a very time consuming alternative, building your own portfolio through and app like Robinhood) might be the best bet for setting savings aside in stocks that might be doing better for the world.

Ultimately, there may be an innate contradiction here. Prioritizing ESG goals over profitability is counter to what public companies are designed to do: Maximize value for the shareholder. Becoming a Benefit Corporation or obtaining a B Corps certification is a way for a company to express to the public the firm’s prioritization of the ESG factors. Benefit Corporations are supposed to value all stakeholders equally: This includes those that do not hold shares in the company, like penguins in Antarctica and orcas off the coast of Washington, or even the neighbors that live down the street from the plant. Benefit Corporations agree to “commit to creating public benefit and sustainable value in addition to generating profit.” This seems like a well-meaning endeavor, since there are transparency and auditing requirements for a Benefit Corporation from an ESG standpoint.

Certified B Corps are those that might not be registered Benefit Corporations but are willing to be more transparent in an effort to display to the public that they strive for ESG progress. We could then certainly assume that a Benefit Corporation or a certified B Corp probably values ESG issues to a greater extent than a company that does not go to the effort to register as such or to become certified. Since nearly all of these companies are private, we can vote with our dollars by supporting these firms with our business, a campaign B Corp, the certification group, is currently marketing.

One last option for individual “impact investing” might be a financial instrument tied to climate and environmental projects, like green bonds. One new example of something like this is Forest Resilience Bonds. This type of investment vehicle was developed by a startup that is looking to connect National Forest Service forest restoration activities with private funds. FRBs are brand new, and I came across this while listening to a recent Returns on Investment podcast from ImpactAlpha. The whole episode is worth a listen, especially if this topic interests you.

Conclusion

In the end, there are five main options available today for putting our dollars into companies that we see as mirroring our convictions:

• Purchase the company’s stock or bonds
• Purchase ETFs that include the company’s stock or bonds, provided that the investor also approves of the remainder of the portfolio, resulting in a more passive investment approach
• Invest in a portfolio through a firm like Swell, which takes a more active management approach
• Invest in green bonds
• Support those companies through buying their products

Each of these options will give different results and have very different impacts, and choosing one will depend on your goals, willingness to actively manage your portfolio yourself, and aversion to or acceptance of fees. Purchasing company stocks and bonds individually can eliminate expenses depending on how it is done, however it requires up-front time on the part of the investor, as well as follow-up work to ensure that the portfolio remains balanced over time. Buying an ETF offers the investor the lowest cost option while also maintaining the balancing and index-following features of a portfolio. I believe that spending the time to decide which kind of investor you are is important, since it could cost you significantly in the long term, especially since not everyone’s goals are the same. Educating yourself is important, and if you need to find someone to help you, keep in mind the principal-agent problem. You are your own biggest advocate. And you should use that power to do what you think is best, for you and for the world around you.

I am always trying to learn and improve. If you have any suggestions, corrections, ideas or other comments, please reach out to me at sustainabilityinthebalance@gmail.com

1. This particular ETF uses a full-replication approach, which means that it does indeed purchase the securities that it lists in its portfolio. Some ETFs are not designed this way and instead can use other securities as a way of mirroring an index. ↩