The future of ESG investing is customizable

Over the past decade, investors have poured a record amount of money into so-called sustainable investments. According to data from Morningstar, funds with a focus on environmental, social, and governance issues saw assets balloon to $1.7 trillion last year, marking a 50% increase from the prior 12 months. But behind the eye-popping growth is a different story; one in which off-the-shelf ESG funds do not live up to its billing. 

Bigger doesn’t always mean better

Take the iShares ESG Aware MSCI USA ETF (ESGU). The world's largest ESG ETF claims to invest in companies with favorable ESG policies and screen out those in controversial sectors. That means names like Altria or American Outdoor Brands never make it into the fund. But when it comes to fossil fuel producers, many of which have drawn the ire of environmentalists, the fund has a footprint in the sector that nearly mirrors the S&P 500. It is unfortunately a common theme among ESG funds. 

Among the other holdings in the $16 billion iShares ESG fund are Apple, Microsoft, Amazon, Google, and Facebook. The five tech giants make up just over 20% of the fund, as of April 28, 2021. Now compare that to the S&P 500. It turns out the same five names also comprise 20% of the large-cap index fund. The key difference between the two is the price tag; a large-cap ETF that tracks the S&P 500 will often charge less than its sustainable counterpart. 

So when Tariq Fancy, the former chief investment officer of sustainable investing at Blackrock, recently said sustainable investing, the way it is commonly delivered, was nothing more than "marketing hype" and a "PR spin," he had a point. Many of the fastest-growing funds look a lot like products that investors already own, just with a shiny green label. 

The hidden risk of off-the-shelf ESG funds

But Fancy's comments may not be the biggest issue. Most investors have probably read the criticism leveled against ESG, namely that the funds are greenwashed and companies need a single reporting standard. Where it becomes a problem is when an off-the-shelf ESG fund leads to concentration risk or fund overlap. This happens when investors hold multiple funds with many of the same positions. For those who already own a large-cap fund, the prospect of investing in a generic ESG fund would greatly increase their exposure to Big Tech. And in doing so, it may erode the benefits of diversification and expose them to unintended risks. 

The difficulty is in finding and preventing this from happening. It can be easy to track down repeat names among two or three funds, but it becomes a challenge when investors own a handful of ETFs or mutual funds. Even after that, there's the issue of removing the duplicate exposure. An ETF or mutual fund allows for a few options; remove the fund altogether or deal with the additional risk, amongst more. Although the former removes any potential sources of risk, it also removes potential sources of uncorrelated returns. 

ESG the right way

A better solution may lie in technology. Recent innovations in financial technology have made it easier for advisors, and their clients, to screen would-be sustainability investments. Some of the most popular methods are direct indexing or custom indexing. Both approaches contend that directly owning individual securities in a separately managed account (SMA) can better accommodate a client's values than a portfolio of ETFs and mutual funds.

It does this by letting advisors handpick individual assets or sectors that align with their client’s goals and preferences. For instance, advisors can remove fossil fuel producers from their client’s portfolio even if the underlying ETF maintains a footprint in the sector. It's not just the E in ESG, either. The S and G are just as customizable. Perhaps a client wants a more precise way to invest in companies with female board members or executives. Just as fossil fuels can be removed, an advisor can add to their client’s positions in female-led companies like Pepsi or GM. The ability to do this at a granular level makes sustainable, and even values-based, investing much more meaningful for clients. 

There’s still a risk that handpicking stocks can lead to concentration risk or overlapping positions. Fortunately, technology helps address that, too. Modern investment platforms which offer these services are designed to monitor for overlapping exposure throughout an investor’s managed portfolio and external holdings (e.g., employee stock options). So even if they were overweight in a specific sector, they’d know the risks of that decision right away.