Let’s say you like to invest according to your conscience and believe in the sustainable or ESG movement that scores companies based on how well they adhere to environmental, social and governance principles. Would you invest in Total S.A.—the French oil and gas company? How about steelmaker Commercial Metals Co., which consumes lots of resources to make its finished products? Or even Mattel Inc., which has produced countless plastic toys in its long history?

ESG purists would likely thumb their nose at these companies, but they appear in certain ESG-focused strategies and fund portfolios. And that pretty much sums up the quandary of what exactly is meant by the trendy buzzwords of sustainable and ESG investing, along with impact investing and SRI, which can mean either socially responsible investing or sustainable, responsible and impact investing.

No matter what it’s called, this slice of the investment world is clearly gaining momentum among both institutional and retail investors. Financial industry A-listers including BlackRock, State Street Global Advisors and Goldman Sachs, among others, have made sustainable investing a priority. And much has been made about generational and gender-driven attitude shifts in investing, with millennials and women as leading forces behind the growing focus on ESG principles.

According to Morningstar, the sustainable funds universe comprised 303 mutual funds and exchange-traded funds in 2019 across three broad types: ESG focus, impact/thematic and the sustainable sector. And the fund research company said that $21.4 billion poured into sustainable funds in 2019, a nearly fourfold increase over the prior year.

Still, the $140 billion in ESG assets at year-end was less than 1% of the total assets in U.S. mutual funds and ETFs. But that also means there’s plenty of room for growth.

In a report, Morningstar analyst Jon Hale noted that two overarching issues have helped fuel the growth in sustainable/ESG investing. “The first is climate change, and the second is the growing critique of the shareholder-primacy view of the corporation,” he wrote. “Now, rather suddenly, we seem to have reached a tipping point on both issues.”

The International Monetary Fund explained in a report from last October that concerns about risk management, benchmark underperformance and a need to demonstrate material ultimate impact led to the evolution of ESG strategies away from negative screening that excluded firms or entire sectors from investment portfolios, and more toward positive screening for companies with good ESG performance.

The IMF report gave a wishy-washy conclusion about the investment performance of ESG-related funds, stating that there’s no conclusive evidence that sustainable funds consistently outperform or underperform conventional funds. It noted that restricting investments can reduce diversification benefits and limit investment opportunities, leading to underperformance. On the flip side, it posited that ESG factors could allow asset managers to identify companies with higher long-term-value creation while avoiding assets with mispriced costs from extreme events like climate change.

Morningstar has a more upbeat view regarding performance, noting that 35% of sustainable funds that it covers finished in the top quartile of their respective investment categories last year and 66% were in the top half. At the very least, that paints a picture that investors don’t have to take a hit when they try to do good for the planet, society and corporate governance.

But one of the criticisms of ESG-style investing is the lack of clarity about what sustainability or ESG means, let alone how to measure it. In early March, the Securities and Exchange Commission issued a request for comment on a standing rule aimed at eliminating misleading fund names by requiring at least 80% of a fund’s holdings to match the stated investment objective of the fund’s name.

In specifically citing ESG funds, the SEC asked several questions, including how such funds determine whether a particular investment satisfies one or more ESG factors; whether these determinations are reasonably consistent across funds that use similar names; and should ESG funds be required to explain to investors what they mean by the use of these terms?

Some asset managers share that circumspection. “ESG is incredibly subjective,” says Vitaliy Katsenelson, CEO and chief investment officer at Investment Management Associates Inc. in Greenwood Village, Colo. “It can mean different things to different people. It’s really made to make us feel better, but a lot of times it’s just fluff.”

He says he doesn’t consider ESG when constructing separate accounts for his clients. “My job is to be a capitalist and a capital allocator, and not to run social filters,” Katsenelson explains, adding he’ll overlay clients’ wishes on top of his decisions.

“So if I want to buy a tobacco stock, we don’t buy it for a client who doesn’t want tobacco stocks,” he says.

Active Vs. Passive
Skeptics also point out that certain ESG funds resemble garden-variety U.S. large-cap funds. Looking at a small sample size consisting of the largest and fourth-largest socially responsible ETFs, the $3.5 billion iShares ESG MSCI U.S.A. ETF (ESGU) and the $1.8 billion iShares MSCI KLD 400 Social ETF (DSI), along with the $1 billion Vanguard ESG U.S. Stock ETF (ESGV), which tracks a FTSE Russell index, all three are tech-heavy products with financials representing the second-largest industry sector. And bellwether names including Microsoft Corp., Facebook Inc., both share classes of Alphabet Inc., Apple Inc., Visa Inc., Mastercard Inc., Procter & Gamble Co. and the Home Depot Inc. appear as top 10 holdings in at least two—and some in all three—of those ETFs.

Nicolas Rabener, managing director of FactorResearch, did a factor exposure analysis of ESG funds and found that ESG factor performance shares some common trends. “So the underlying portfolios likely have overlapping stocks,” he wrote last year in a blog on the CFA Institute’s website.

Specifically, he noted, ESG factors exhibited negative exposure to the value and size factors, which have both generated negative returns since 2009, and had large positive exposures to the low-volatility and quality factors. “The low-volatility factor was the best-performing factor since 2009 and accounts for much of the positive excess returns derived from ESG factors,” he said.

The herd mentality among some index-based ESG funds shows the potential benefit of active management in the ESG space, says Frances Tuite, co-portfolio manager of the ESG equity strategy at Fairpointe Capital LLC, an investment management firm in Chicago.

“Some of the passive ETFs that focus on ESG have been heavily weighted to technology and financial names, and these sectors have lower carbon footprints, but they’re not necessarily good companies in terms of how they manage their workforce, and we’re seeing privacy issues with some of these companies,” Tuite says. She notes that Fairpointe does its own rating system of companies, and that can turn up surprising ESG candidates such as Commercial Metals, a steel company that uses 99% recycled materials to make its rebar.

“They use electric furnaces instead of coal furnaces. They recycle their water in their steelmaking process. They have a woman CEO,” Tuite explains. “People will look at it on the surface and see it’s a steel company and say, ‘Oh, I don’t want to own that.’ There are nuances to ESG that I think are overlooked.”

In that vein, Tuite also likes Mattel. “They make a lot of things from plastic, which is based on fossil fuels, but they’re aggressively moving to making products from cornstarch and ethanol-based plastic.” She adds the company is striving to minimize its packaging and to use recyclable, compostable and sustainable packaging, and that it has improved its corporate governance.

Robert Smith, president and chief investment officer at investment manager Sage Advisory Services in Austin, Texas, says his firm has been doing responsible investing since 2004.

Sage offers a number of ESG strategies on the fixed-income side, and Smith says the same criteria exists for both fixed income and equities. “We’re looking at industry-level analysis in terms of the E, S and G,” he says, adding that his team then looks at each individual company by itself.

He notes that Sage doesn’t exclude oil and gas companies from its strategies. “Some people recognize that by cutting out a large part of the marketplace, you’re inducing a tremendous amount of risk in your portfolio from a performance standpoint,” Smith says. “If one wants some exposure to the oil market, a company like Total would be a good example of a leader in the industry in terms of where it intends to go and its actions in terms of execution.”

He offers that Total is making “transformative” strides in growing its renewable energy business. “We’re trying to induce good behavior as opposed to admonishing bad behavior, which was the old SRI model,” he says.

To Smith, sustainable companies are those that maintain their business model and strengthen it on an ongoing basis to improve resource management and interactions with all of their stakeholders including shareholders, communities and the human capital of their employees.