It’s What’s Inside That Counts…
Earlier this month, investors poured about $1.25 billion into a new BlackRock ESG fund, the BlackRock US Carbon Transition Readiness ETF. According to Bloomberg, this was the biggest launch of an ETF in the exchange traded fund industry’s 30-year history. First day inflows like this are typically driven by institutional investors that have been briefed and prepared to invest prior to launch. However, the early days success of this ETF in attracting investors is also emblematic of the rapidly growing interest in ESG investing, an investment approach that considers values-oriented factors as part of the investment process.
ESG stands for “environmental, social and governance” - ESG investors consider the impact, both positive and negative, that corporations are having on our environment and our society, as well as how they conduct themselves from a governance standpoint. There have been concerns over how ESG factors are defined, as well as a lack of consistency in measurement across companies and industries. Furthermore, some ESG funds are not dissimilar to large cap index funds in terms of returns and holdings. In particular, some ESG ETFs resemble their tech-oriented brethren in their concentration of “FAAMG” stocks, an acronym that stands for “Facebook, Apple, Amazon, Microsoft and Google/Alphabet”.
Consider the following chart of top holdings in four popular ESG ETFs (including the aforementioned new release from Blackstone) versus the Invesco QQQ Trust, an ETF which seeks to track the performance of the Nasdaq 100 technology stock benchmark.
Since many investors may already own FAAMG stocks either individually or through a mutual fund/ETF wrapper, the ESG ETF buyer should beware that they might be duplicating exposures held in their portfolio, thereby increasing concentration risk. Furthermore, while analysts have applauded ESG funds for their solid returns, citing their sustainable and socially responsible business practices as drivers, there is another factor at play - the FAAMG stocks have grown exponentially in recent years, especially during the pandemic. So how much of ESG fund manager success to date is due to investing in tech stocks (not to mention avoiding energy stocks, which were pummeled last year) versus ESG factors as a predictor of success? Furthermore, should an ESG investor be concerned that some of these businesses are under scrutiny for monopolistic behavior, labor practices and data privacy, factors which seem like they should fall on the spectrum of ESG concerns?
To be clear, I am not discounting ESG as an investment practice. Rather, I think there are more targeted ways to invest in businesses that are making progress on important initiatives such as carbon emissions, diversity, equity and inclusion in the workplace, waste management, and ethical business practices, to name just a few. One approach might be to invest in a thematic fund that focuses on a specific sector, such as a clean energy or intelligent infrastructure. Another approach might be to create your own ESG ETF through custom indexing (see my previous blog on this topic - https://www.insightfiduciary.com/post/direct-indexing-is-it-right-for-your-portfolio). You can start with a particular ETF or benchmark and then eliminate stocks which already represent a concentration in your portfolio or that go against your values, all while potentially generating tax alpha and lowering expenses.
So, if a Gen Z-run asset manager launches a hot new ESG ETF – the “US Large Cap Boomers at Fault ETF” (Ticker: WTFB) - don’t forget to take a close look at what’s inside of it before you invest.