Want to invest your conscience? Here's how to pick an ESG fund that matches your values and financial goals

A new breed of investor has been drawn to ESG funds. But criteria used to pick stocks for these portfolios can vary. This guide looks to arm investors with information to find the funds that most closely align with their values.

Updated Tue, Aug 2 2022

Jesse Pound @/in/jesse-pound @jesserpound

12 min read

The ESG investing trend exploded before regulators and major investing firms had a strong agreement on the definition of the phenomenon, making it difficult for investors to figure out how to best spend their money. The booming category, which looks at environmental, social and governance factors to rank companies, has created wildly different outcomes across different investment firms. In one recent example, automaker Tesla — arguably the highest-profile green energy-related company in the United States — was booted from the S & P 500 ESG index in May, while oil giant Exxon Mobil made the cut. Tesla CEO Elon Musk declared ESG ratings the "devil incarnate," and it's fair to say many investors were likewise puzzled. Even the total amount of assets in ESG funds is unclear. The Global Sustainable Investment Alliance estimated that assets held by ESG funds totaled around $35 trillion at the end of 2020, and that number is sure to grow when the group releases its next report. But using a more narrow definition for just sustainable equity funds, RBC pegged the number at $1.3 trillion. That number, too, is showing tremendous growth. "[Assets under management] in sustainable equity funds grew 60% in 2020 and 49% in 2021, which far exceeded AUM growth for traditional funds," RBC said in a note to clients in July. Fund flows have been positive, though slower, in 2022, according to RBC, even amid a market downturn during which oil stocks were among the rare winners. ESG has become a dominant topic in corporate boardrooms, with shareholder motions for carbon-friendly policies at major companies cropping up regularly from small activist funds like Engine 1 and given some heft by companies like asset management behemoth BlackRock . Evaluating these shifts can be a daunting process for professional fund managers and CEOs, let alone for smaller investors. A well-intentioned buyer might purchase funds labeled as ESG only to find they now own shares of major energy companies or firms caught up in high-profile scandals. A lack of standardization in the industry means that ESG is a series of judgment calls, from the individual investor level to research teams and portfolio managers. "One of the challenges in the ESG space is that the whole point of it, at least how I think about it, is to get people's capital aligned with their values," said Bill Davis, portfolio manager at ESG-focused Stance Capital. "And then, of course, as a manager that's not necessarily what we're doing. We're aligning them with our values, and then hoping their values line up with our values. In general, we're not creating a completely bespoke portfolio for every investor that comes along." How to read this guide This guide from CNBC Pro is intended to show readers the choices different portfolio managers and ratings firms are juggling as they give ESG scores. The goal is not to create a list of approved stocks, but to arm investors with the foundation to ask the right questions about how their money is being handled. Follow along from start to finish, or jump to the section(s) you want to learn more about. Environment The "E" in ESG is the biggest focus for many investors who want to build sustainable portfolios. The first thing many fund managers and index providers need to decide is if they will have any "hard lines" for their products. For the environmental segment, that could come in the form of banning all fossil fuel companies completely or more narrow definitions, such as companies that use or produce thermal coal. Other funds will instead use an approach that finds the most ESG-friendly stocks in each sector to create a more balanced portfolio. "One of the things that we wanted to achieve with these products, because they are meant to be core building blocks of a portfolio, is not to take any idiosyncratic risks … understanding that there were going to be energy and utility companies that make up a portion of the process," said Chris Huemmer, senior investment strategist at FlexShares. His firm has several different ESG funds including some that use a vector score developed by parent company Northern Trust . Picking the best performers in a carbon-intensive sector also fits into one theory of ESG, which is to reward companies that are changing their behavior. Goldman Sachs , for example, publishes lists of stocks that are "ESG Improvers" or "Greenablers." Those lists include several utility and energy firms, as well as mining companies. Another consideration is that different types of companies have different types of risks. Many firms will use sector-specific rating factors to make sure companies are not getting undue credit or blame for something that is not core to their business. "When you're looking at a utility company or an energy company, obviously things like greenhouse gas emissions and air quality — those are primary factors in the financial materiality of the effect of ESG on those corporations," Huemmer said. "Whereas if you're looking at a financial firm, things like data security, product quality and safety and customer rights — those are the things that rise to the surface." Northern Trust and some leading ratings providers, such as MSCI, use the financial impact of climate risk on companies to help develop their ESG scores. One benefit of this, according to Huemmer, is that it can help cut down on so-called greenwashing because small green-energy projects that are not core to a business have only a tiny weight on the total score. However, HumanKind Investments CEO James Katz is skeptical of the focus on the financial impact lens used by other firms, saying that it can lead to companies receiving stronger scores for minor shifts in their business even if their overall impact on the external environment doesn't change. "A company that moved a factory from the coast up into the mountains now gets an improved 'E' score, because it's less likely to be flooded as the result of climate change. But does that mean that they are mitigating climate change in any way?" Katz said, using a hypothetical example. Social The "S" portion of ESG has some overlap with environmental concerns, but it can encompass products the company sells and also how it treats its workforce and other stakeholders. "We try to put a dollar value on every impact that a company has. Not just on investors, but also customers, employees and society at large," Katz said. Again, there are potential hard lines to consider here. Weapons and tobacco, for example, are two areas that many ESG investors will look to avoid. Getting penalized in one portion of an ESG score, including social, can counteract goodwill that is built up elsewhere. Part of the reason Tesla was removed from the S & P 500's ESG Index, according to S & P Dow Jones Indices, was because of the allegations of racism and poor working conditions at the company's plant in Fremont, California. The social component can also be an area where business can get a boost in some scoring, such as at ratings provider MSCI . The firm includes metrics for opportunities in categories like access to health care or access to communications. Julia Giguere-Morello, head of Americas core ESG and climate research at MSCI, cited neglected tropical diseases or other infectious diseases in certain geographic areas as an example of where companies can improve their score. "If a company operates in that particular country, it may have a high opportunity exposure to address that specific need," Giguere-Morello said. News events can push a previously under-the-radar policy of a business into an ESG risk, and this can often fall under social. For example, after the beginning of the Covid-19 pandemic, Stance Capital added paid leave as a risk factor, noting the impact that the spread of the coronavirus was having in manufacturing companies. How quickly to react to company-specific news is another consideration. Stance's Davis cited Facebook , after the Cambridge Analytica scandal , and Wells Fargo , when it was accused of opening accounts without customer knowledge , as two examples of when Stance decided to remove a fund based off of a current event. Humankind, however, waits until its once-a-year rerating process to assess events. Time can show that the scandal was not as bad as feared or that the company has taken steps to improve, Katz said. "Headlines can be misleading sometimes. We don't want to act with our gut and make a very emotional decision on something that should be very carefully thought out," he said. Governance While the environmental and social categories are quite broad, the governance category is typically more acutely focused on a company's upper management and key decision makers. The MSCI framework for governance, for example, includes scores for ownership, the board of directors, how pay is determined for executives and accounting metrics. MSCI can also make deductions based on business ethics and taxes. While MSCI uses industry-specific metrics for its overall strategy, its governance framework is "universally applied," according to the executive summary for its ESG methodology. A staff education paper from the Financial Accounting Standards Board also lists "antibribery and anticorruption" and "lobbying and political contributions" as governance considerations. The FASB ESG framework can be a building block for firms to construct their own policies, including Northern Trust's vector score . Once you want to compare companies, you pretty quickly end up in an apples and oranges situation unless you keep it at a reasonably high level. Portfolio manager, Stance Capital Bill Davis One example of how governance scores can be affected is by how much control a small group of individuals have over a company. Dual-class stock structures, or a board led by the CEO, can be sources of possible demerits. ESG categories have some overlap, including the governance and social segments. For example, some firms can use the diversity of a board of directors and executives as a factor in the governance score. "We basically think that diverse boards, independent board members, diverse members of management teams, lead to better governance, which leads to better performance," said Davis of Stance Capital. Data issues and potential regulation For fund managers and ESG index providers, making dozens of decisions to create an ESG framework can be light work compared to actually applying those rules to companies. Many companies, for example, will not disclose the carbon emissions from every part of their business or detail all their supply chain partners. And when trying to compare one company to another for potential inclusion in a portfolio, investment pros need to weigh not only the different scores but also how to adjust for a lack of transparency. "Once you want to compare companies, you pretty quickly end up in an apples and oranges situation unless you keep it at a reasonably high level," Davis said. As ESG has become a bigger focus in recent years, companies have started to disclose more data. However, many fund managers and other investment professionals say there may be a need for more standardization or regulation to make the data more comparable. "The disclosure landscape is getting better and better. It's really at this point about sifting through all of that data and finding what's the most financially relevant and then comparing and standardizing across companies," MSCI's Giguere-Morello said. One way many firms try to account for missing or mismatched data is to pull in information from third parties, such as industry groups or nonprofit organizations. For investors looking to pick the funds that are best for their ESG goals, some standardization could be coming soon from the Securities and Exchange Commission. The regulator in May proposed a set of rules for investment advisors and funds that want to promote their ESG credentials, such as disclosing the greenhouse gas emissions tied to their portfolios. Impact on investors Since the rise of ESG, investors have had one major concern: Can they truly expect high returns with funds focused on sustainable investing? In the back half of the last decade, with oil stocks lagging and Wall Street turning its attention to electric vehicle and solar stocks, attractive returns seemed achievable. ESG funds outperformed more traditional funds, and stronger environmental regulations from regulators in Europe and elsewhere seemed to be shepherding more companies toward compliance. However, the spiking oil prices in 2022 have sent energy stocks soaring, casting some doubt on that thesis. And funds that focused heavily on a company's carbon footprint could be overweight smaller, high-growth companies, which might create extra risk for a portfolio during market downturns. "Well under one-third of global, U.S., and European focused actively managed sustainable funds are beating their benchmarks in 2022 and track records have also been weak relative to their traditional fund peers. January and 1Q22 as a whole were particularly tough periods for sustainable funds (relative to their traditional fund peers)," a report from RBC said in July. "We would note that generally, we have found that sustainable funds still slightly exceed their traditional fund peers on most longer-term 3-year and 5-year performance measures, though the gaps have narrowed meaningfully this year," the report said. BlackRock, the world's largest asset manager, was one of the most vocal supporters of a shift toward sustainable investing in recent years. But the firm appears to have bumped up against some limits to that vision in 2022, supporting a smaller share of ESG-related shareholder votes this year and saying that some seemed "less supportable" or overly prescriptive. Still, BlackRock CEO Larry Fink has not fully backed down, and he said in his January letter to CEOs that environmental concerns in particular will be a major factor in investment decisions and performance going forward. "Every company and every industry will be transformed by the transition to a net zero world," Fink wrote. "The question is, will you lead, or will you be led?"