How Socially Responsible Investing Lost Its Soul

(Bloomberg Businessweek) -- “It’s easy to invest in what you believe.”

That’s the pitch for TD Ameritrade’s foray into socially responsible ETFs, one of the year’s hottest financial crazes.

Whether it’s climate change or gender diversity, today’s activist age has spawned an array of funds designed to appeal to millennials with a cause. And everyone, from BlackRock Inc. to Goldman Sachs Group Inc. and hedge fund titan Paul Tudor Jones, is jumping on the bandwagon.

Yet Wall Street’s embrace has come at a steep price.

All too often, critics say, revenue-chasing triumphs over principles. Investors who think they’re buying environmental, social, and governance funds—ESG for short—to promote a better world often wind up with costlier products that are, in almost every other respect, the same as any index fund. Criteria are so broad and disparate that companies as unlikely as Exxon Mobil Corp. and Philip Morris International Inc., the maker of Marlboro cigarettes, make the cut in some cases.

In other words, ESG lost its soul in the bargain. To the naysayers, what began as a way to make a difference has become little more than an avenue for Wall Street to reap big profits, all while gaslighting the American public.

“There’s a lot of greenwashing,” says David Krysl. A 28-year-old data science analyst from San Diego, Krysl was one of those millennials motivated by the prospect of doing good when he went to invest about $10,000 of retirement savings. Fossil fuels, guns, and cigarettes were no-nos. He wanted to reward companies with women and people of color on their boards.

After poring through scores of different options—many of which he found wanting—Krysl used some of his money to buy a clutch of ESG funds from Nuveen, whose tag line reads: “Align your investments with your values.” But recently, he learned one ETF owns Coca-Cola Co.—which he says is sucking up water rights around the world. (Nuveen says Coke’s water-stress issues have been “less severe” than its peers, and the company scores highly on its carbon footprint and waste.) Krysl is considering moving his money again.

“They’re just banking off most people not having the time to really look.”

It’s not hard to see why. As fees tumble toward zero in the $3.5 trillion U.S. market for exchange-traded funds, asset managers are desperately trying to come up with new products to sell and more ways to generate revenue. Many have zeroed in on slicing and dicing the investment universe into ever more specific themes (see robotics ETFs), or styles such as momentum.

Though many funds are backed more by marketing than science, they all have one thing in common: higher fees, which firms say are justified because they do something more sophisticated than tracking the stock market.

And these days, the hot new thing is ESG, a story that Wall Street can sell. In the past three years, ETF assets have more than tripled in the U.S., to $7 billion. Almost three-quarters of the funds have started since 2015. And more than 6,000 separate ESG indexes were created in just the 12 months through June.

“There’s been a rush to occupy this space with not much substance,” says Francesco Ambrogetti of the United Nations Capital Development Fund, which helped design an ETF that donates its fee to the organization. “They promise a lot but don’t have a serious, rigorous system in place.”

Granted, ESG is still a tiny sliver of the fund universe. But the fees have money managers seeing dollar signs. Compared with the iShares Core S&P Total U.S. Stock Market ETF, which costs 0.03 percent, investors pay on average 15 times more for do-gooder ETFs. (Nuveen, which charges 0.2 percent to 0.45 percent, says its prices reflect a methodology that’s more akin to active management.)

That means an ESG fund managing $100 million can easily outearn a vanilla ETF that has over $1 billion in assets. With millennials such as Krysl projected to inherit some $30 trillion in coming decades, it’s no wonder ESG has become such a big deal. BlackRock, for instance, will introduce sustainability scores for more than 700 iShares ETFs early next year.

Cutting out entire industries invariably hurt performance. However, if Wall Street could convince the investing public that an ethical choice could also be a reasonably profitable one—that could be a big moneymaker. So as the buzz around ESG grew, firms reinvented the category as a catchall for any company trying to do better in its field.

Take the $1.2 billion iShares MSCI KLD 400 Social ETF. It promises “exposure to socially responsible” companies and can be used to “invest based on your personal values.” Yet a quick look shows it owns half the S&P 500. A Vanguard ESG fund holds 4 out of every 5 stocks in that index.

BlackRock declined to comment on the overlap between its ETF and the S&P 500, saying it’s ultimately about how investors want to achieve their financial and ESG goals. Vanguard Group says its fund can be used as a core holding by those interested in sustainable investing.

The largest holding in a $22 million OppenheimerFunds ETF is Exxon Mobil, which has been accused by regulators of misleading investors about the cost of climate-change regulation. The fund, which buys companies with “best in class” ESG practices and shuns those that score poorly on controversies, also owns Philip Morris and at least three defense contractors. Oppenheimer says the companies garner above-average ESG scores, based on third-party research that specializes in sustainability analysis.

The irony is that, while ESG funds look and act more like your average ETF (about 10 beat the S&P 500 in the past year), many ordinary investors aren’t all that fussed about returns. Those who spoke with Bloomberg said they were skeptical about how ESG funds were labeled and complained about the lack of products aligned with their particular priorities, such as worker welfare. Performance wasn’t a primary reason in their decision-making.

“Millennials are the ones that want to invest in companies where their dollars are not going toward killing the whales,” says Jay Gragnani, head of research and client engagement at Nasdaq Dorsey Wright, which runs an ESG managed account. “It’s probably pretty difficult for the average investor. There’s a lot of information out there and, in some respects, too much information.”

That’s partly because there’s little agreement over what constitutes ESG. Fund managers use different rules made by different index compilers, all of which can lead to radically different assessments for the same company. Lower emissions or a good safety record may win over millennials worried about environmental or social issues. However, institutions might reward a company simply for good governance—even in an industry like oil production.

Even proponents such as Matthew Bartolini, head of Americas research for State Street’s ETF business, say ESG isn’t an exact science. The firm’s low-carbon target ETF, for example, owns Royal Dutch Shell Plc.

“Is it really the purest form of clean power? Probably not,” he says. “There’s no true-north definition of ESG. That’s why you’re seeing a lot of different products come out.”

Indeed, fund providers often focus on the “G” in ESG because it can be easier to quantify and measure. On Main Street, though, they continue to market ESG as a way for Americans to align their money with their values.

Some are trying to make that true. Impact Shares, which started its first ETF in July, works with the NAACP and the UN, and donates its fees to charity. Others are ditching ETFs altogether. Swell Investing, where Krysl has most of his money, offers separately managed accounts that allow investors to buy stocks around specific themes, like disease eradication, and exclude names they don’t like.

“We’re pushing a model where people are consciously putting their money toward things they care about,” says Jake Raden, who co-heads Swell’s impact team. “I’d hope that over time, ESG products fit more holdings-wise with what they purport to be, or that they change how they market themselves.”

To contact the editor responsible for this story: David Papadopoulos at papadopoulos@bloomberg.net, Michael TsangLarry Reibstein

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