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.”