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Sustainable Investing: A dirty secret: Here’s why your ESG ETF likely owns stock in fossil-fuel companies

Some of the biggest environmental, social and governance exchange-traded funds have exposure to fossil-fuel companies and “sin” stocks like gambling and tobacco firms.

These broad-based passively managed ESG ETFs are marketed as ready substitutes for traditional core fund exposures. Studies from research groups such as Morningstar and NYU Stern Center for Sustainable Business show ESG funds can do as well as the broader stock market.

Here’s the dirty little secret: many of these funds can track the S&P 500 SPX, -0.81% or other well-known indexes because they designed to be sector-neutral, rather than favoring one sector over another. So while they can avoid those companies with the worst ESG ratings, they can’t completely exclude energy companies or sin stocks yet still represent the broad market.

On top of that, most renewable energy companies don’t count as energy stocks. The Global Industry Classification Standard sectors that the S&P 500 and others use say that the energy sector comprises firms in all aspects of the fossil-fuel industry. Renewable energy companies are generally found in the industrial, utilities or materials sector. For example, panel maker First Solar FSLR, -1.85% resides in the industrials sector, while Brookfield Renewable Partners BEP, -0.46% is in the utilities sector.

True, ESG funds can set the criteria that feeds into these customized indexes, but institutional investors pay a lot of attention to the “tracking error”—in this case, the difference between the custom index and the broader market.

“It ultimately comes down to they (asset managers) don’t want to have big tracking error, because the bigger the tracking error rate, the less likely institutional investors are going to be to put money into the portfolio,” says Peter Krull, CEO of Earth Equity Advisors, Asheville, N.C.-based financial planners focused on sustainable, socially responsible and impact investment management.

Some of the biggest ESG ETFs take a broad, sector neutral stance, such as the $24.9 billion iShares ESG Aware MSCI USA ETF ESGU, -0.78%, $6 billion Vanguard ESG U.S. Stock ETF ESGV, -0.86% and $3.3 billion Xtrackers MSCI U.S.A. ESG Leaders Equity ETF USSG, -1.17%.

There’s nothing misleading or greenwashing about these passive ESG ETFs since the funds state it in their methodology. Krull says he’s fine if an ESG ETFs states it uses ESG ratings in its methodology and leaves it at that.

But he says the investor confusion, and what he calls greenwashing, comes if an asset manager tries to call any fund that only uses ESG metrics a sustainable fund.

Sustainable investing is more than metrics, he says. The point of sustainable investing is to using personal values to invest in companies the person believes will have a positive impact and outperform in the long run, the basis of the idea of “doing well by doing good.” Many sustainable funds are actively managed, rather than passively follow an index, which can introduce active risk and may have higher fees.

Inside how ESG ETFs are built

Many passive ESG ETFs are designed and created for institutional investors or family offices with significant wealth, not with the little guy in mind. Sometimes asset managers launch ETFs because they see a potential market opportunity.

Index providers will create whatever a client wants, including to excluded entire industries or sectors. But an index without energy may not appeal to a pension fund which has some degree of fiduciary obligation and may not be able deviate significantly from a traditional index, says Vikram Gandhi, senior lecturer in the entrepreneurial management unit at Harvard Business School.

“If the investor is a big family office and says I do not want to invest in natural resources, the asset manager will be very happy to create an ETF that has no energy companies in it,” Gandhi says. “But I would argue that most large fiduciary holders of assets would not be able to invest in that ETF.”

That’s been an issue in the past year energy stocks became the best-performing sector in the S&P 500. One of the few passive large-cap ESG ETFs, the $120 million Change Finance U.S. Large Cap Fossil Fuel Free ETF CHGX, -1.38%, that has no exposure to the energy sector, is up 8.9% over one year, including dividends, through Feb. 9, trailing the MSCI USA Large Cap Index’s 17.3% one-year return.

Deviating too much from traditional market-cap-weighted indexes introduces some form of active risk into the portfolio, says Matthew Bartolini, head of SPDR Americas research at State Street Global Advisors. That can support or detract from returns depending on what investments are in or out of favor.

In its ESG ETFs, State Street tries to blend what it believes is a fair representation of the broader benchmark, such as its $1.38 billion SPDR S&P 500 Fossil Fuel Reserves Free ETF SPYX, -0.83%, the largest of its 11 ESG funds. That fund has a one-year return of 18.1%, also including dividends, through Feb. 9 versus the S&P 500’s 18.9% one-year return.

The word “reserves” is doing the heavy lifting in the Fossil Fuel Reserve Free ETF. It doesn’t own companies that produce fossil fuels, but the fund holds refiners and utilities that use fossil fuels to produce electricity.

“We try to focus on the name of the fund Fossil Fuel Reserves Free, not ‘fossil fuel free,’ because if it was fossil fuel free, we would probably only own about five companies,” Bartolini says. “Think about airlines. What do they use?”

He says the firm tried to design the fund to provide a representative slice of the broad market.

“If there’s a clientele that wants…to allocate to the S&P 500, but does not want to do it where they own the largest emitters of fossil fuels, this is a way to do it,” he says.

Know what you own

Funds may bill themselves as sustainable or using ESG, but that doesn’t mean they have the same strategy, says Jon Hale, head of sustainability research for the Americas at Morningstar.

Morningstar created a framework that identifies six approaches used by ESG fund issuers: applying exclusions; using ESG data to limit risk or find opportunities; engaging with companies; targeting a specific investment theme; or assessing the impact of security selection.

ESG ETFs that focus more on impact rather than just ESG material risks and opportunities could be better suited for an investor who wants to own companies with a larger purpose and less about matching a broader index return.

Gandhi says there’s a simple solution for ETF investors: Look at the holdings before buying. “If an ETF has energy companies in it and it doesn’t make you happy, then you should go and find an ETF that doesn’t have energy companies in it,” he says.

More on ESG investing

Can I beat the stock market with ESG investing? How to find the right fund for you

The S&P’s energy sector surged more than 50% last year—so how were green funds able to keep up with the stock market?

Today’s widely adopted ESG ratings and net-zero pledges are mostly worthless, two pioneers of sustainable investing say

Some ETFs mix investing with charities—should you?

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