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ESG Funds Continue to Boom, But Buyer Beware

Investing in ESG funds is growing in popularity (as you can see in the fund flows) but are you really getting what you’re paying for?

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Even in this bear of a 2022 market, ESG stocks remain resilient. Mutual funds and ESG funds (which stands for environmental, social and governance) saw net inflows of $120 billion in the first half of this year, according to Morningstar. That’s in stark contrast to net outflows of $139 billion from broader market funds over the same time period.

The reason is simple: investor preference. People increasingly want to use their investment capital to support companies that act toward the greater good as part of their pursuit of profit. But are you really getting that when you buy ESG funds?

It’s easy to know part of this: what constitutes an environmental stock is clear. Ultimately, carbon dioxide increases global warming, so not emitting carbon, or reducing it, is a clear bar. Companies that do that are what populate the universe of 300 U.S.-listed cleantech stocks I cover for the Cabot Sector Xpress Greentech Advisor.

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Gauging if a stock is good on “social” or “governance” is trickier because those definitions are harder to frame. There is no set definition of what makes a business a benefit to society or an exemplar of good governance. They’re both desirable qualities that lead to good shareholder and societal outcomes, but they’re often in the eye of the beholder. Is Meta Platforms (META) a social good because it connects people around the world to others? Or is not an ESG stock because of its persistent role in spreading misinformation about elections? Plenty of people would heatedly argue one way or the other.

To many funds, this gray area means they can call anything they want an ESG stock. Consider the largest U.S. ESG ETF, the iShares ESG Aware MSCI ETF (ESGU). In its top 200 holdings, which account for $17.1 billion assets, or almost 89% of the fund, it holds more than $1 billion (about 6%) in 13 companies whose businesses are focused on the production or emission of fossil fuels, including ExxonMobil (XOM). Exxon is the fund’s seventh-largest holding. As a reminder, it’s a company that actively funded climate change denial for decades and, according to the Climate Accountability Institute, is the fourth-largest contributor to carbon emissions since 1965, two notches behind another ESGU holding, Chevron (CVX).

How do oil and gas producers get into an ESG fund? It’s because ESG index providers, mainly MSCI, rate companies on a relative basis to their peers, not overall. Therefore, presumably ConocoPhillips (COP), which is the 15th most-weighted stock in ESGU’s 317 holdings, is somehow better, ESG-wise, than a company not in ESGU’s holdings, such as W&T Offshore (WTI). MSCI says ConocoPhillips is in the top half of peers in environmental metrics. The company emitted 16.2 million tons of CO2 equivalents in 2020 – more than Canada. Though I focus on ESGU here, most ESG funds have this problem: they sell you ESG, but it’s honestly hard to see what that means.

I help subscribers to SX Greentech Advisor cut through this noise. Each year I tally the top 50 most widely held ESG stocks for their reference. And in every issue, I choose three ESG stocks that look great from a technical analysis view as potential investment ideas to explore, beyond our regular buy recommendations for our two actively managed portfolios focused on clean tech stocks. With my “ESG Three,” I say why a company is ESG, how much ESG funds own, and why it’s a good stock now. Fossil fuel producers need not apply. Often, the approach surfaces gems for subscribers.

In our September 21 issue, I highlighted Eli Lilly & Co. (LLY) as one of the ESG Three. Lilly is ESG because it’s better than its pharmaceutical peers at the three ESG metrics and also maintains a robust employee engagement program. Happy, engaged employees are proven to be more productive – an early finding that helped lead to today’s ESG movement. The day we featured Lilly, shares closed at $298 a share. It’s gained $35– nearly 12%, in the month since. A strong drug pipeline, including an Alzheimer’s treatment that could get fast-track approval this year, is behind the market-besting momentum. It constitutes almost 1% of the assets of ESG fund universe, by my tally.

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Brendan Coffey, Chief Analyst of Cabot SX Greentech Advisor, has been immersed in investing for more than 25 years, including as an investment advisory editor, investor, markets reporter and writer about and for a wealth of Wall Street’s most influential minds. He’s discussed investing strategy with the likes of Carl Icahn, Mark Cuban and Leon Cooperman and collaborated with hedge fund managers and entrepreneurs on books and essays. He’s written about investments and markets for Forbes, Bloomberg, Fortune, The Wall Street Journal and numerous other outlets.