Why ESG Investing Needs More Precision and Clarity

Industry jargon is part and parcel of the financial markets. “ESG integration” has become a common buzz term on Wall Street following decades of rhetoric about the need to factor environmental, social and governance risk when investing. After all, the risks and opportunities posed by climate change, executive compensation and social responsibility are too big to ignore.

Today, ESG-focused funds consist of fossil fuel companies and globalization heavyweights like Wal-Mart and McDonald’s. Banks with scandalous pasts, like HSBC, are also pushing the ESG agenda, leaving many in the financial community wondering about whether we need an industry-wide definition of the term.

At present, there is no consensus on what ESG actually means or how to measure it. There are at least five reasons why this is the case.

To learn more about socially responsible investing, refer to this article.

Given how broad the ESG umbrella has become, it’s difficult to distinguish this approach from plain vanilla strategies, which are the most standard types of funds. Since nobody has standardized ESG investing, it’s difficult to separate it from the broader vanilla strategies available today.

That’s why several energy-related ESG funds (those with “fossil fuel reserves free” in their title) have come under criticism. ETFdb.com’s Socially Responsible ETF List contains several of these funds, including the SPDR MSCI EAFE Fossil Fuel Reserves Free ETF (EFAX). The SPDR MSCI ACWI Low Carbon Target ETF (LOWC A-) may be a better option, since it aims to overweight environmentally friendly stocks.

ESG may have its heart in the right place, but there’s a lack of a concise definition of what it entails.

This is the underlying reason why fund managers struggle to get on the same page when it comes to defining ESG parameters. For example, how does one invest in fossil fuels from an ESG perspective? Better yet, how does one not invest in it? The SPDR MSCI Emerging Markets Fossil Fuel Reserves Free ETF (EEMX) narrowly defines this parameter, but still contains companies that have questionable environmental records. The fact that many of these companies are based in China is itself a cause for concern, given that the world’s second-largest economy is also the world’s biggest polluter.

Investors with an environmental conscience may opt for the Etho Climate Leadership U.S. ETG (ETHO ), which tracks select U.S. equities based on the smallest carbon impact within their respective industry.

When it comes to ESG investing, information is extremely sparse about how asset managers actually integrate the strategy in their fund selection. For example, some fund managers include solar and wind energy funds, while others do not. This was confirmed by the Global Sustainable Investment Alliance, which recently noted a huge divergence in how funds select their stocks.

For example, it’s not entirely clear what the Global X S&P 500 Catholic Values ETF (CATH ) stands for from a disclosure perspective. Although the fund adheres to the guidelines set forth by the U.S. Conference of Catholic Bishops, it has an equal representation of energy companies as the S&P 500. Given that the environmental component is a huge part of ESG, some investors would take exception to this rubric.

When it comes to disclosure, the iShares MSCI USA ESG Select ETF (KLD B) does a pretty good job. The fund caps the weighting of individual stocks so the portfolio doesn’t diverge sharply from the broader market. At least we know what we’re getting.

Not only is there no consensus on what constitutes good or bad ESG strategies, there’s no agreed-upon way to enter this market. What one person considers to be ethical from an environmental, social or governmental perspective might not be shared by others. That’s why there’s so much disagreement on how ESG strategies should invest in fossil fuels. This conundrum ultimately compelled State Street to change the name of its ESG fund to the SPDR S&P 500 Fossil Fuel Reserves Free ETF (SPYX ).

The ETF is exposed to 476 S&P 500 companies that are presumably outside the fossil fuel industry. Yet at the same time, it includes several companies that have faced scrutiny for their polluting supply chain.

Although the iShares MSCI KLD 400 Social ETF (DSI B) suffers from the same set of circumstances, the fund has developed a risk/return profile that is generally consistent with the benchmark of U.S. equities.

For a deeper analysis on individual ETF investments such as (SPYX ) or (DSI B), use our ETF Analyzer Tool to compare funds along multiple criteria.

With so many diverging opinions about what constitutes ESG, fund managers naturally have different sets of criteria for screening companies for inclusion. This is especially the case when screening which energy companies make appropriate investments, or which so-called “Biblical” funds live up to Christian ethics. Some funds, like the State Street ETF, contain companies that are completely blacklisted by others.

One clear criteria for ESG investing is offered by the Barclays Women in Leadership ETN (WIL C), which invests in stocks with women as CEOs or board members.

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ESG is an exciting concept, but still has a long way to go before it becomes a reliable investment strategy. Until then, investors are encouraged to research these funds critically. For a primer on sustainable investments, read Five Sustainable Investing Trends in 2017.

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