ESGU iShares Trust iShares ESG Aware MSCI USA ETF

By Akane Otani 

Funds with a focus on socially responsible investing are enjoying a record year of inflows. But many such portfolios aren't as clean as investors might expect.

Eight of the 10 biggest U.S. sustainable funds are invested in oil-and-gas companies, which are regularly slammed by environmental activists, according to a review of the funds' public disclosures.

ESG funds, which broadly market themselves as trying to invest in companies with strong environmental, social and governance practices, have taken in a record $13.5 billion of net new money from investors in the first three quarters of the year, according to Morningstar.

Although most of the top funds exclude gun makers, casino operators and tobacco companies, they have been slow to reduce their exposure to fossil fuels.

That can sometimes seem at odds with the language funds include in their prospectuses.

For instance, BlackRock Inc. says its iShares ESG MSCI USA ETF aims to track an index of companies with "positive environmental, social and governance characteristics." The fund includes Exxon Mobil Corp., which is awaiting a ruling in a trial involving allegations that it misled investors about how it accounted for climate-change regulations. A spokesperson for the oil giant says the allegations in the lawsuit are baseless.

Vanguard Group's FTSE Social Index Fund is meant to track an index excluding companies with "significant controversies regarding environmental pollution or severe damage to ecosystems." Both that fund and another large ESG fund operated by Xtrackers include Occidental Petroleum Corp., which in 2015 paid Peruvian indigenous villagers an undisclosed sum to settle a suit accusing it of contaminating the Amazon.

A BlackRock spokesperson said the firm has designed its sustainable funds to offer investors similar risk and returns that they would achieve in broad market indexes while including the highest ESG-rated companies in each sector. A Vanguard spokeswoman referred questions about the firm's fund to FTSE Russell, which runs the benchmark on which it is based. Representatives of FTSE Russell, Xtrackers and Occidental couldn't be reached for comment.

To be sure, energy shares account for a small share of the funds' overall holdings. For instance, they make up about 4% of the iShares ESG MSCI USA Leaders ETF, 4% of the Xtrackers MSCI USA ESG Leaders Equity ETF and 2.7% of Vanguard's FTSE Social Index Fund. In comparison, energy shares account for 4.3% of the S&P 500's total market capitalization, according to S&P Dow Jones Indices.

Complicating matters, what constitutes a strong or weak ESG rating can vary widely from firm to firm.

"The biggest frustration on behalf of investors is there's no standardization within this industry," said Rebecca Corbin, founder of capital-markets research and advisory firm Corbin Advisors.

But the fact that conventional energy companies are included at all in the funds illustrates how asset managers that have devoted increasing resources to developing sustainable investing strategies have been slow to exclude big energy.

"It's hypocritical at its core," said Leslie Samuelrich, president of Green Century Capital Management Inc., which runs three fossil-fuel-free funds. Many of the firm's clients are investors who were surprised to discover that their retirement funds, touted as ESG funds, held shares of oil-and-gas companies. "Most investors don't spend a lot of time looking under the hood. But I think if more knew that they were in fossil fuels, they'd think twice," she said.

Analysts offered various reasons for why asset managers have been slower to screen out energy stocks than other types of firms.

One simple explanation: No asset manager wants to deliver subpar returns. Energy stocks have been a losing bet this year. But research from the Federal Reserve Board has shown U.S. recessions have often followed periods when oil prices have run up rapidly. During those times, energy shares have often been among the few sectors to reliably produce gains -- making them an important group for asset managers, said Nicholas Colas, founder of DataTrek Research.

That is especially true for asset managers whose products are aimed in part at institutional investors, which often have less room to miss their target returns.

Also, an oil company that scores poorly on one element of ESG -- say, the "E" -- might do well on the other two elements, meriting its inclusion in a fund, Ms. Corbin said. Similarly, the same company might be included in an ESG fund because its environmental score is better than industry peers.

Still, other analysts say it is a mistake to assume that ESG investing means having to prioritize values of sustainability at the expense of healthy returns.

"There is no reason why competitive ESG indexes can't be built without oil and gas exposure," said Jon Hale, head of sustainability investing research at Morningstar.

One such fund, the Invesco Solar ETF, has soared 51% this year -- more than doubling the S&P 500's 23% gain. Another, the iShares U.S. Home Construction ETF, has risen 48%. Among the more popular ESG funds, Vanguard's FTSE Social Index Fund is up 26%, while iShares' ESG MSCI USA ETF has risen 24%.

Despite that, the clean-energy funds have had paltry inflows compared with their ESG counterparts that include oil-and-gas companies. The data suggest that there isn't enough demand among investors for clean funds to cut offerings more aligned with broad benchmarks.

"You're not going to pick up the phone and call your broker and say, 'Dump everything, I want everything in ESG,' " Mr. Hale said, adding that it will take time for investor attitudes to change.

Write to Akane Otani at akane.otani@wsj.com

(END) Dow Jones Newswires

November 11, 2019 16:44 ET (21:44 GMT)

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