An investment vehicle managed by experts who take environmental, social, and governance (ESG) considerations into account when selecting how to create the fund’s holdings and allocate its assets is referred to as an “ESG Fund” in general.
ESG fund managers employ a variety of investment strategies, such as eliminating certain industries, concentrating on particular themes, or directly integrating ESG aspects, making it difficult to understand their precise composition.
ESG mutual funds, ESG exchange-traded funds, and ESG index funds are the three main types of ESG funds. ESG factors are incorporated into these funds’ investment strategies.
ESG funds come in a variety of formats, and fund managers use a variety of ESG-focused methods.
ESG funds are subject to the same risk of “greenwashing” as publicly traded corporations, where the appearance of ESG alignment may not correctly reflect the fund’s actual practices.
ESG Fund Construction
To construct their portfolios, ESG fund managers can use a variety of strategies, such as creating their own internal ESG standards or depending on external ESG ratings provided by organizations like ISS, CDP, or MSCI (among others).
While this is not an exhaustive list, some examples of ESG investing techniques are as follows:
A technique called negative screening, also referred to as exclusion, involves identifying unfavorable characteristics (which fail to meet particular sustainability benchmarks or standards) and then using a stock screening tool (such as Refinitiv or Capital IQ) to eliminate investments that don’t meet the requirements.
Negative screening is in contrast to positive screening, also known as inclusion. Asset management organizations’ teams of analysts and fund managers have the option to do screens to find top performers (often evaluated by the same external rating agencies) based on important ESG benchmarks.
The screening tool may seek out remarkable results across the board, or it may concentrate on finding top performers in the “S” (social) element, or a particular subset like diversity, equality, and inclusion (DE&I), or corporate culture measures. Platforms for the capital markets are designed to let analysts screen securities at a high level of detail.
In the context of ESG, thematic investing entails ESG fund managers identifying broad macroeconomic trends that they believe have promising futures and are well-positioned to collectively improve environmental (E), social (S), or governance (G) outcomes.
BlackRock is frequently credited with making the idea of thematic ESG investment more broadly embraced. Thematic ESG funds may still use screening methods, but a sizable portion also rely on internal models and standards to meet their investment objectives.
Understanding ESG Funds
Stricter requirements for the disclosure of portfolio composition were introduced and put into action by worldwide financial regulatory authorities in 2022, particularly those in the US and the EU. This project sought to reduce instances of fund managers making false claims on ESG or giving misleading information. Greenwashing is the word used to describe such false ESG claims.
Additionally, fund performance disclosure must be made, principally to protect individual investors. ESG funds are comparable to traditional funds in this way.
ESG Mutual Funds
ESG mutual funds are professionally managed investment vehicles that use pre-established ESG criteria while choosing bonds and stocks. Investors can benefit from these funds’ diversity, liquidity, and skilled management.
Similar to publicly traded firms, mutual funds are required by law to disclose their performance and pertinent fund operations to the public.
ESG Exchange Traded Funds (ETFs), which include a variety of ESG-focused stocks, bonds, and financial instruments, resemble mutual funds in certain ways. ETFs are freely traded on stock markets, in contrast to mutual funds, which are bought and sold through the issuing institution.
ETFs typically have lower costs than mutual funds, notably lower management expense ratios (MERs).
ESG Index Funds
ESG mutual funds include ESG index funds as a subcategory. An ESG index fund follows the performance of the ESG-focused firms listed in an index, such as the S&P 500, while ESG mutual funds are actively managed by a portfolio manager.
Examples of ESG index funds are the Fidelity U.S. Sustainability Index Fund (FITLX) and the FTSE Social Index Fund (VFTAX) from Vanguard.
ESG & the Analyst Community
Financial analysts must be able to clearly articulate the following elements when establishing an ESG fund or assessing its performance for prospective inclusion in a client’s investment portfolio:
Investment Strategy: It is essential to describe the proposed investment strategy and justification for the fund.
Measurement of Incorporated ESG Concerns: It is crucial to define the ESG issues that have been incorporated into the process and to explain how they have been measured.
ESG Criteria Impact: It is crucial to show how the applied ESG criteria help to reduce risk or create value at the fund level.
Finance professionals run the danger of aggravating the ongoing issue of greenwashing if they don’t have a thorough comprehension of the investment rationale or criterion.
ESG disclosure requirements and laws are likely to become more stringent, not less, according to anticipated trends. Due diligence on ESG-labeled funds and their creation by investors will probably become more rigorous as a result of this.