Record Flows Pour Into ESG Funds as Their ‘Wokeness’ Is Debated

Exchange-traded funds built on environmental, social and governance themes have attracted record inflows this year, as the U.S. grapples with the pandemic, devastating weather and racial unrest.

But for anyone looking to invest with conscience, it might pay to check under the hood.

Inflows to ESG ETFs have surged to $22 billion so far in 2020, already about three times the 2019 total, according to data compiled by Bloomberg. The trouble is, the label isn’t policed by U.S. regulators, and no one can quite agree how to weigh ESG components — resulting in some surprising fund holdings.

BlackRock Inc.’s iShares ESG Aware MSCI USA ETF (ESGU) includes stakes in Exxon Mobil Corp. and Chevron Corp., for example, while its biggest holdings are in tech companiesunder investigation for monopoly abuse. Stocks in Xtrackers MSCI USA ESG Leaders Equity ETF (USSG) include McDonald’s Corp., which has come under scrutiny for its treatment ofemployees.

“If you go in there thinking that you want to ‘woke’ up your portfolio, and you see those companies, you’re going to be like, ‘What? That’s not what I signed up for,’” said Eric Balchunas, ETF analyst for Bloomberg Intelligence.

Top Dogs

Three BlackRock products dominate the ESG fund market and make up the majority of total assets. BlackRock’s iShares ESGU, iShares ESG Aware MSCI EM ETF (ESGE) and iShares ESG Aware MSCI EAFE ETF (ESGD) account for about $13.4 billion of year-to-date flows.

BlackRock works withMSCI Inc. to set its funds’ inclusion and exclusion rules. MSCI, whichscores ETFs based their holdings’ environmental, social, and governancerisks and opportunities, rates ESGU and ESGD as AA, one level below the top ranking, while ESGE is rated A.

ESGU’s indexscreens for companies involved in civilian firearms, controversial weapons, tobacco, thermal coal and oil sands. A peer fund from Vanguard Group takes a stricter approach: Its $2.2 billionESG US Stock ETF (ESGV)excludes companies involved in adult entertainment, alcohol, tobacco, weapons, fossil fuels, gambling and nuclear power.

The ESG category is inherently subjective, said Ben Johnson, Morningstar’s global director of ETF research. While investors may want to “tip their hat” to ESG, many don’t want to fall too far behind benchmark performances.

About 53% of respondents to a recent Nuveensurvey cited better returns as their reason for choosing responsible investing. Only 51% were more interested because of this year’s natural disasters.

“The preponderance of assets in ESG funds are in ESG light funds,” Johnson said. “The level of spiciness, if you will, goes from mild to medium to hot — in terms of where the assets are right now, it’s all in pico de gallo.”

Raters Disagree

Complicating socially conscious investing is the fact the Securities and Exchange Commission doesn’t regulate how the ESG label is applied, though it’sconsidering adding rules for funds that call themselves ESG or sustainable.

Independent ESG rating companies around the world have sprung up to fill the gap. But they don’t always see eye-to-eye. A 2019paper from MIT Sloan School of Management found the correlation of five raters’ ESG scores averaged 0.61, compared with a 0.99 correlation of credit ratings from Moody’s Investor Services and S&P Global Ratings.

Differences can arise in weighing a company’s overall actions. Amazon.com Inc., for example, has been accused ofdangerous warehouse practices, but haspledged to become net carbon neutral by 2040.

Bloomberg LP, the parent of Bloomberg News, is developing an ESG scoring system. And Bloomberg Intelligenceanalyzes climate change funds by looking at their carbon exposure.

“The question on everybody’s mind now revolves around green washing,” said Shaheen Contractor, ESG analyst for BI, referring to companyefforts to create an undeserved image of environmental responsibility.

That’s a concern for Dylan Tanner, executive director of InfluenceMap, an organization that provides data and analysis on how businesses are impacting the environment.

“Some of the data providers who rate companies on ESG tend to firstly rely on a company’s own disclosures and sustainability reports too much,” he said. “How meaningful those numbers are, when you’re blending climate with labor, should be questioned.”

Get on Board

Issuers have realized the benefits of ESG branding. At least eight funds have relaunched this year to switch to the strategy, versus a maximum of two in previous years, according to data compiled byBloomberg Intelligence.

There have been 17 ESG ETFs launched so far in 2020, compared with 10 in all of 2019. And the inflows keep coming. ESG funds have already taken in almost $4.1 billion in October, on track for their best month since at least 2013.

Another reason could be that issuers like BlackRock are using their ESG ETFs in their model portfolios, suggesting that organic market demand might be less than it than appears, according to BI.

“The good news for ESG proponents is that BlackRock is the biggest money manager, and they have a lot of influence,” Balchunas said. “If they are putting their money where their mouth is, that can’t hurt.”

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