Environmental, social, and governance (ESG) investing has continued to be supported by large institutional portfolios as well as regular retail investors. All in all, more than $323 billion worth of investor assets now sit in dedicated ESG funds. Globally, that number is closer to $2.5 trillion. This doesn’t include other endowments or portfolios run with ESG guidelines.
Despite the promise, ESG funds aren’t without their issues. Political items aside, the construction of some ESG funds and indexes is leaving investors a bit flat. This is why investors may want to go active with their ESG holdings.
It turns out that active has a real advantage when it comes to ESG, meeting mandates, and generating better returns. The best part is there is a whole host of new active ETFs that focus on the investment style, promising better returns with a low-price, single-ticker package.
ESG & Its Indexing Issues
The early ESG movement was all about exclusion. Managers and index providers simply removed problem firms from their portfolios and benchmarks. Firearms, tobacco, and oil companies were verboten. That worked well for many fund providers to meet growing ESG mandates. Unfortunately, returns for many early ESG funds were lacking.
As with many areas of the market, investors started to look for more. And that’s where the modern ESG movement started. Index providers started screening and assigning scores to various companies and their metrics. This allowed investors and index providers to create a different set of ESG stocks. For example, major index provider MSCI digs into public data and filing information on over one thousand different data points. Those points are further broken down to 80 exposure metrics, 129 management issues and 37 industry-specific parameters to score individual stocks. ,
The issue is what MSCI and a lot of other index providers do with all these data points. Just take a look at this chart courtesy of asset manager AllianceBernstein.
Source: AllianceBernstein
As you can see, many of the top holdings of the non-ESG-based MSCI ACWI Index are the same as two major ESG-focused indexes. This has many investors crying foul that many ESG funds are simply closet index funds, tracking major market benchmarks. What’s worse is that many ESG funds charge more than broader benchmarked ETFs. Investors are paying higher fees for the same basket of stocks.
Second, the title ‘ESG’ doesn’t necessarily mean the same thing across various funds and indexes. For example, some indexers will simply rank stocks on their ESG scores, while others try to keep the sector weightings the same versus a parent index. This means an ESG index could include an oil company or defense firm.
For investors looking at index funds for their ESG assets, this is where it gets dicey. You could be expecting X and actually get Y. Meanwhile, returns can be crimped by higher fees for essentially a broad market index, while expected mandates aren’t being met.
Active ETFs to the Rescue
The answer for investors could be to go active with their ESG assets.
The beauty of active management is you don’t have to follow a broad market index to build your portfolio. In the case of ESG, that could be a real win. Managers can use ESG scores and data as a starting point to build their portfolios. This can mean creating their own ranking systems, using ESG data as a funnel for stock selection, commingling bonds and stocks, and even omitting firms with stock/fundamental issues even though they may score well on ESG. After all, it doesn’t matter if a firm has perfect ESG metrics if they have debts and deteriorating cash flows.
Moreover, active ESG managers can go beyond data and look at active engagement. How is a firm changing and how are those changes going to potentially affect its bottom line? Committing to using less water in a process doesn’t show up on a data score. Active managers can also push firms to act a certain way through proxies and voting.
The end result is a better return. A study by Neuberger Berman shows that over rolling one- and three-year periods since 1999, active ESG strategies beat their passive peers more than 60% of the time after fees. Moreover, cumulative excess returns over the last 20 years active versus passive ESG was nearly 35% for U.S. funds and 110% for global and non-U.S. funds. 1
Going Active in ESG
ESG from an indexing point of view has plenty of faults. Active management can overcome many of those issues by digging into the data, building different portfolios, and putting boots on the ground. The inefficiencies inherent in ESG allow for exploitation and better performance.
And it turns out that’s exactly what investors want in an ESG portfolio. A recent study by Capital Group of 1,130 professional investors in 25 countries showed that more than 63% preferred active ESG funds to passive ones. The main reason cited was “inconsistent and inaccurate ESG scores” along with “huge subjectivity in ESG ratings.” Active managers are better suited to meet those challenges. 2
For that reason, it may make sense to go active with your ESG holdings. Luckily, the ETF boom has created plenty of active ESG funds to do just that.
Active ESG ETFs
These ETFs were selected based on their low-cost exposure to ESG while using active management. They are sorted by their YTD total return, which ranges from -1.1% to 15.2%. They have expense ratios between 0.35% to 0.95% and have assets under management between $5M to $546M. They are currently yielding between 0.5% and 5.1%.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| PLDR | Putnam Sustainable Leaders ETF | $479M | 15.2% | 0.5% | 0.59% | ETF | Yes |
| TEMP | JPMorgan Climate Change Solutions ETF | $24M | 13.1% | 1% | 0.49% | ETF | Yes |
| ESGA | American Century Sustainable Equity ETF | $198M | 10.5% | 0.9% | 0.39% | ETF | Yes |
| SROI | Calamos Antetokounmpo Global Sustainable Equities ETF | $11.1M | 6.9% | 0.9% | 0.95% | ETF | Yes |
| BKUS | BNY Mellon Sustainable US Equity ETF | $8.6M | 4.9% | 0.7% | 0.60% | ETF | Yes |
| EMNT | PIMCO Enhanced Short Maturity Active ESG ETF | $176M | 2.5% | 5.1% | 0.36% | ETF | Yes |
| PCRB | Putnam ESG Core Bond ETF | $546M | -1.1% | 4.3% | 0.35% | ETF | Yes |
For investors, ESG has plenty of promise. The key to unleashing that promise is to go active. Active ETFs allow managers to overcome many of the issues that occur with ESG indexing. By focusing on more than just scores and how they rank stocks, active managers can truly craft a better performing portfolio. The proof is in the pudding with higher excess returns and consistent benchmark-beating outcomes.
The Bottom Line
When it comes to ESG, investors should get active. Thanks to the ability to overcome some major glaring indexing issues, active management allows ESG to truly shine. With investor preference growing for active ESG strategies, the number of active ETFs in the area is growing. Investors should consider them for their portfolios.
1 Neuberger Berman (January 2019). ESG Investing: An Active Approach to Long-Term Value Creation
2 Capital Group (April 2023). ESG Global Study 2023