Investing in ESGs has taken a controversial turn in recent weeks as some states have targeted the sustainable funds.
This month Florida banned its $186 billion pension fund from investing on ESG factors. And in Texas, the state comptroller accused 10 financial firms of boycotting energy companies. The move could force certain Texas state funds to sell stakes in those companies.
BlackRock was among those named in the indictment, although the company said in a statement it was not boycotting oil. But the shift in sentiment has led to increased scrutiny of the composition of ESG funds.
“Actually, it’s relatively simple, we don’t boycott energy companies,” Arne Noack, head of systemic investment solutions for the Americas at DWS, told Bob Pisani on CNBC’s ETF Edge on Wednesday.
DWS is a major provider of ESG ETFs, including the MSCI USA ESG Leaders Equity ETF (USSG) and the S&P 500 ESG ETF (SNPE).
“[USSG and SNPE] hold between 4% and 5% in energy companies, which is in line with the S&P 500,” he added.
Noack said that USSG, for example, is broadly sector neutral compared to the benchmark MSCI USA Index, but only invests in companies that perform better than average from an ESG perspective.
The politicization of sustainable funds arises in particular from the question of what the products do and promote and what factors are taken into account in the construction.
“ESG stands for Environmental, Social and Governance, and the focus has been on the ‘E’ part of it,” Todd Rosenbluth, head of research at VettaFi, said in an ETF Edge interview on Wednesday. “Whether companies are too focused on climate change and what’s related to it.”
Rosenbluth explained that the strategies are broad and are evaluated against 30 different sub-factors. Climate change is one of them, but so are issues such as fair wage practices and gender diversity.
Some of the largest ESG funds have significant holdings in the energy industry. According to VettaFi, BlackRock’s ESGU and SUSA ETFs have 4.8% and 3.8%, respectively, in companies like Baker Hughes, Chevron, Exxon Mobil, Halliburton, and Valero Energy. The weighting of energy stocks in these funds is in line with the S&P.
“So how can you favor ESG and still have exposure to these large-cap energy multinationals?” Rosenbluth said. “You can have both. These should be broadly diversified products.”
The ESG industry is made up of 186 sustainable ETFs, according to VettaFi, which make up 6% of total exchange-traded funds worth about $100 billion. That’s about 1.5% of the dollar value of the entire ETF business.
While efforts have been made to standardize and codify the meaning of ESG, the challenge remains to accurately define the products.
“We’re talking about funds that have different objectives, all of which are valid,” Mona Naqvi, global head of ESG capital markets strategy at S&P Global Sustainable1, told CNBC’s ETF Edge on Wednesday. It just depends on the individual investor: Some want to separate completely, that’s fine. Some want to hire companies to work with them to improve, that’s fine too. But I think painting all sustainable funds with the same brush and expecting the same results…it hurts the many different individual perspectives investors have and the choice we should be giving to investors in a free market.”
The process of greenwashing is another hot topic affecting the ESG industry. The term refers to when a company promotes a questionable green agenda by giving distorted impressions or misleading information about how its products are more environmentally friendly.
“I would not say [greenwashing] is a big problem,” said Noack. “They describe very clearly the underlying methodology and therefore make very transparent to what extent the ESG scores are used and not used.”
As a fund manager of ETFs, Noack said they have no discretion to deviate from the methodology and fully adhere to the rules, which are published in their prospectus.
“As a concept, it’s very easy for us to all agree on the definition [of greenwashing]’ added Naqvi. “But what does that mean in practice and how do you know when you see it?”
Naqvi cited the example of oil companies being included in low-carbon ESGs. What if the company diversifies and shifts more to renewable energy each year, she asked, or what if it has more green to brown or gray revenue?
“We have trouble defining ESG,” she said. “Defining greenwashing is even more difficult in many ways.”
SEC Chairman Gary Gensler has asked for more clarity and specific rules for product labeling. His proposed measures would prevent US funds from making misleading or deceptive claims about their ESG credentials and increase disclosure requirements.
“That’s a very reasonable request,” Noack said. “It is very much in our interest that our investors have a very clear understanding of what they are investing in. Having standards that everyone has to adhere to makes perfect sense to me.”
Strive recently launched its US energy ETF (DRLL) in a bid to roll back money managers’ alleged stakeholder capitalism. The fund performs similarly to the S&P Energy Index at higher costs.
According to Strive, the fund intends to use its shareholder engagement and proxy voting to unlock the potential of the U.S. energy sector by rejecting short-sighted policy agendas that it says have caused companies to invest too little in American oil, natural gas and investing in other forms of energy.
“Investors have choices,” Rosenblum said. “If you care that your energy company is going too far towards clean energy and you want to be part of a strategy.”
But Rosenblum added that most investors aren’t worried about how big companies like BlackRock vote on what to put in their funds, and that Strive is taking a more political approach to the issue.
“They call it capitalism in a different way,” he said. “It’s an ETF investment and should perform the way you ultimately want it to.
The debate lingers on whether an ESG fund’s success is due to profit or purpose, although the two don’t necessarily cancel each other out. While recent defensive moves by government agencies and industry alike pose a unique challenge to the future of sustainable funds, Naqvi stressed that time horizon is crucial.
“If you look at a very short time frame, certain things might seem more profitable,” she said. “But once you take that longer-term view, things like reputational considerations, potentially looming carbon taxes, and pricing that makes investments less viable matter.”