Many ESG funds don’t invest sustainably

Indexes, benchmarks and tracking error keep funds from investing more sustainably

As I scroll through the list of ESG mutual funds and ETFs on Morningstar, I am always surprised by how few I would buy for my clients. The word “greenwashing” gets thrown around a lot, but if you look under the hood at the holdings of these funds, you should understand why.

You would often find names like ExxonMobil and McDonalds, which are not brands one would normally associate with the environmental or corporate responsibility. But because so many ESG funds are based on traditional indexes, it’s hard for the managers to deviate very far from the original benchmark’s holdings. Likewise, many institutional investors are hung up on tracking error, so managers don’t really have a choice.

I preach all the time that you can’t invest in the future by looking in the rearview mirror, but that’s what we see with ESG index investments. We rarely see innovating companies focused on sustainability and positive impact. We see watered-down versions of traditional benchmarks that are rooted in the old economy.

Less bad is still bad

ESG is a set of metrics used to analyze a company. It is not meant to be the sole rationale for creating the final portfolio. When taken out of context, or arbitrarily used, ESG metrics leave us with indexes that make you scratch your head wondering, “How did that stock get in the sustainable portfolio?”

The best way for me to describe these investments is: An ESG index portfolio that reduces its exposure to ExxonMobil is less bad; a portfolio that eliminates the holding entirely is better; but a portfolio that replaces it with First Solar – an American solar panel manufacturer – is sustainable. Unfortunately, most ESG indexes do not include positive, solutions-based companies like First Solar.

As long as institutional investors have their low-tracking-error requirements, we will see these greenwashed, less-bad portfolios in the marketplace. For positive, sustainable portfolios to become common, institutions must alter their investment policies to allow non-index-based portfolios in the mix. It’s time to stop watching the rearview mirror and instead look ahead to see where we’re going.

Investing intentionally

ESG is just one piece of the analysis process and should be considered as a single component of comprehensive investment research. A sustainable portfolio is intentional and requires forethought and analysis beyond fundamentals and ESG metrics. It involves a deep understanding of our new economy and which industries and companies are leading us to a more sustainable future. It considers which companies will be the changemakers and market leaders, pushing the envelope for a cleaner economy, greater resiliency and a social conscience that we don’t currently see in our corporate entities.

In some cases, these companies might be in traditional industries and are being proactive, rapidly adapting to a changing world. Or they might be focused on a technology that didn’t exist five years ago. Opportunities exist in sustainable real estate and green building technologies, as well as in the rapidly expanding world of batteries, electric vehicles and other forms of green transportation. And beyond the obvious industries like clean energy lie areas such as cutting-edge biotechnology to cure disease and help people live longer, healthier lives. A healthier society is a more sustainable society.

ESG funds need to see beyond the traditional benchmarks and take a positive, solutions-based approach.

Because many ESG funds are marketed as sustainable, most retail investors make the incorrect assumption that when they purchase an ESG fund, they are purchasing something different, something that will help the planet. If they learn that their portfolios are simply less bad and lack companies offering positive solutions, they can become disillusioned to ESG investing as a whole. We need to work to change this.

To achieve truly sustainable portfolios instead of ones that are less bad, we need to move beyond traditional indexes, let go of tracking error requirements and adopt an investment philosophy focused on positively and intentionally investing in solutions.

Peter Krull is CEO of Earth Equity Advisors.