About Those New Vanguard ESG ETFs

Sustainability Matters

The problem is that these funds aren’t really ESG funds, at least not in the sense that I would define the term. Granted, the ESG space has some challenges with terminology reflecting varied approaches, but, for the most part, funds calling themselves “ESG” today explicitly integrate environmental, social, and corporate governance criteria to select companies with positive ESG characteristics.

The typical passive ESG fund tracks an index that is constructed using company-level ESG analytics to tilt its portfolio toward companies that are doing a better job addressing the material ESG risks and opportunities facing their business. For companies in the energy, utilities, and industrials sectors, as an example, that means focusing on issues like carbon emissions; for tech companies, data privacy; for apparel firms, supply-chain oversight. For industries where innovation and expertise are at a premium, ESG analysis may look at pay, benefits, diversity, and corporate culture. Ethical corporate governance, product safety and usefulness, treatment of workers, and community relations are important ESG considerations across the board.

The new Vanguard funds, however, don’t reflect an ESG integration approach. They are throwbacks, evoking the pre-ESG era when “socially responsible” portfolios employed a more-limited negative-screening approach that excludes companies based on their products or practices.

Specifically, the new Vanguard ESG ETFs track FTSE indexes that exclude companies based on three types of products:

Rather than tilting toward companies with better ESG profiles, the Vanguard funds simply use negative screens to exclude a relatively few companies from a broad market index.

So what’s wrong with that? Certainly the funds’ list of exclusions is one that many sustainable investors may support. But plenty of ESG funds offer at least some of the same exclusions while also keeping their primary focus on positive ESG integration. Their investors get a more comprehensive ESG portfolio that leans toward companies with better sustainability profiles.

Vanguard — because it is Vanguard — is likely to attract many advisors and individual investors to these funds because of their low fees: ESGV’s expense ratio is 0.12%, VSGX’s is 0.15%. Many will make their first ESG investment in these funds, and many will think, incorrectly, that exclusionary screening is what ESG is all about. A focus on screening rather than positive ESG integration could also lead to underperformance, depending on how effectively FTSE Russell optimizes the indexes to neutralize the tracking error created by the exclusions.

The slightly more expensive iShares ETFs are based on MSCI ESG indexes that consist of companies with positive ESG characteristics, while also employing a limited number of exclusions for civilian firearms, controversial weapons, and tobacco.

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