Socially responsible investing (SRI), sustainability investing, Environmental, Social, and Governance (ESG) investing, impact investing.
They may sound like jargony industry buzzwords. But really, they’re just spokes of a wheel revolving around a very simple investment premise: Putting your money where your beliefs are and avoiding investing in companies that harm the planet or humanity.
You’d think this idea wouldn’t be controversial, right? After all, why shouldn’t you be able to invest in companies that reflect your personal, moral, or political views, no matter where you sit on the political spectrum?
Yet, if you pay too much attention to the avalanche of hostility that has been leveled against this strategy from politicians, pundits, and even some investment advisers, you might be convinced that values-based investing is, at best, a sure-fire way to sabotage your retirement nest egg. Or, at worst, a con game run by trillion-dollar fund companies to make suckers of well-meaning investors.
The controversy over whether values-based funds are worthy investments intensified this year after the Biden administration rescinded a Trump-era Department of Labor directive that aggressively discouraged employer-sponsored retirement plans from offering ESG funds in their plans, despite the strong demand for them from plan participants.
So, in addition to being able to add these funds to your taxable accounts and IRAs, you may soon be able to invest in them through your 401(k) plan.
This is the way it should be. Despite their detractors, most values-based funds offer completely legitimate ways for you to mirror your portfolio to your beliefs, whether you’re a liberal, conservative, out on the edges, or somewhere in between.
As long as you understand the methods these funds use to select stocks and can stomach returns that may beat or trail those of stock indexes or traditional actively managed funds, you shouldn’t feel guilty about adding these funds to your portfolio.
Skyrocketing Popularity is Largely Driven by Women
Once considered a niche product, values-based funds and ETFs have become one of the fastest-growing segments of the asset management marketplace.
According to Morningstar, there were more than 534 values-based funds and ETFs in 2021, triple the number that was available in 2018. What’s more, according to PwC, assets in these funds will double over the next few years, from $4.5 trillion in 2021 to $10.5 trillion in 2026.
Women are largely driving the growth of these funds.
This is because women now manage most of the wealth in America. And they invest for reasons beyond simply maximizing investment returns.
Right now, women control 52 percent of the wealth in the U.S. and nearly half of all estates worth more than $5 million. By 2030, that figure will rise to 66 percent. Over the next forty years, they’ll inherit 70 percent of the $41 trillion of wealth that parents and spouses will pass on to their heirs.
And as these women flex their financial muscles more aggressively, they aren’t settling for investment options whose only purpose is either to mirror the market or outperform it.
Like the retailers and suppliers they do business with or the charities they support, women want to hold the companies they invest in to a higher standard.
According to a survey of investors conducted by RBC Wealth Management, 74 percent of women are interested in learning more about values-based investing and increasing allocations to these funds, compared to 53 percent of men.
And it’s not just millennials. According to Morningstar, women of all ages, from newly minted college graduates to recent retirees, want to become more informed and engaged values-based investors.
Asset managers who refuse to add values-based funds to their lineups do so at their financial peril.
ESG Funds: Myths and Realities
When most people think about values-based investing, ESG funds are the first options that come to mind.
You can thank huge fund companies like Vanguard and Blackrock for that. They’ve done an outstanding job of selling ESG mutual funds and ETFs to investors and popularizing them in the press.
Since ESG funds are the largest, most well-known, and most controversial values-based fund category, we’ll devote the most time to discussing their pros and cons.
ESG funds invest in companies with high ratings in three categories:
- Environmental: The company has demonstrated actions for combating climate change, preserving the environment, maximizing energy efficiency, and managing its use of natural resources.
- Social: Its commitment to providing a positive, beneficial, and supportive working environment for all employees, regardless of race, socioeconomic status, religious orientation, or gender identification.
- Governance: Its commitment to financial transparency, honest accounting practices, reasonable executive compensation, and diversity and independence of its board members.
Can you trust ESG ratings? That’s the trillion-dollar question.
While some asset managers develop their own methods for rating ESG characteristics of companies they’re considering adding to their portfolios, most rely on independent, third-party investment researchers like Morningstar and MSCI.
Critics of ESG investing often point out that these evaluation methodologies are completely subjective and inconsistent. In some situations, a company that earns a rave ESG review from one researcher may get a thumbs down from another.
Other opponents of ESG funds highlight their sector-agnosticism and deceptive marketing practices, castigating ESG fund managers for extolling altruistic virtues while failing to clearly disclose their often-significant holdings in oil and coal mining companies, gambling casinos, and tobacco, alcohol, and firearms manufacturers.
These practices, known as greenwashing, have become so endemic that the SEC is stepping into the fray. They’ve created a task force to identify and sanction asset managers that engage in greenwashing and have proposed new rules to require all ESG fund managers to be more accountable and transparent to shareholders and would-be investors.
Does this mean you should avoid ESG funds altogether? Not necessarily. You just need to spend more time examining a fund’s holdings to see if it invests in companies or sectors you’re opposed to.
Or, you can use independent fund screening resources, like the free Invest Your Values tool from As You Sow, a nonprofit organization focusing on shareholder advocacy.
This tool analyzes the positive or negative climate and social impacts of thousands of U.S. mutual funds and ETFs based on their holdings. You may be surprised at how many well-known ESG funds have failing grades in certain categories.
If you don’t find ESG funds that meet your own investment criteria, there are other categories of values-based funds that may be more suitable.
For example, sector-screening funds don’t grade individual companies. Instead, they avoid investing in certain industries, like fossil fuel producers and arms manufacturers.
Other funds apply their own company-screening criteria to woo investors with common political or religious beliefs. For example, some funds catering to conservative investors won’t invest in healthcare providers that offer abortion services.
Other funds narrowly focus on companies whose core mission is to achieve specific environmental, social, or governance objectives. These impact investing funds are often involved in sectors such as sustainable agriculture, renewable energy, microfinance, affordable healthcare, and housing.
But Will You Make Money?
One of the longstanding criticisms of values-based funds is that investors don’t fully understand how much they’re sacrificing in potential returns.
To bolster their argument, they’ll often benchmark the performance of values-based funds to comparable index funds. If the values-based fund underperformed the index fund, they’ll claim it’s because that fund didn’t have exposure to certain stocks or sectors that made significant contributions to the index fund’s total return.
But what this kind of selective analysis doesn’t tell you is that values-based funds often perform better than index funds.
For example, an analysis from Standard and Poor’s claims that from March 2020 to March 2021, the 19 largest ESG ETFs posted returns ranging from 27.3 percent to 55 percent, compared to the S&P 500’s index’s increase of 27.1 percent during the same period.
However, ESG funds have not been immune to the many headwinds that battered the stock market in 2022. Most of them posted negative returns last year and, according to Bloomberg, 8 of the 10 largest ESG funds underperformed the S&P 500 in 2022.
How will these funds do in 2023? Investor confidence isn’t high. According to a Bloomberg News survey, 65 percent of respondents expect values-based funds to underperform the broader market this year.
While some may see this as a reason to avoid these funds, those with a glass-half-full outlook may view this skepticism as an opportunity to purchase shares of these funds while they’re still relatively undervalued.
So Which Funds Should You Invest in?
Of those advisors in the Wealthramp network who are experts in sustainable investing, many are recommending values-based funds with significant exposure to sustainable technologies. Russia’s invasion of Ukraine and the resulting spike in oil and natural gas prices highlighted the need for countries to reduce their reliance on fossil fuels.
The Biden Administration’s Inflation Protection Act will provide billions of dollars in funding to innovative, well-run companies focused on energy efficiency, electric vehicles, solar and wind power, and carbon footprint mediation. Funds that get in on the ground floor of these companies will be well positioned to benefit from their success in leading the green revolution.
Keep in mind that most values-based funds are actively managed, and therefore charge higher fees than passively managed index funds and ETFs. It’s important to consider the impact of these fees when evaluating your options.
Remember: It’s Not an All-or-Nothing Proposition
Just because you’d like to put more of your money where your beliefs are doesn’t mean that you have to go all-in on values-based investing.
You may want to dip your toes in the water by allocating a small percentage of your portfolio to one or more values-based funds while keeping most of your money invested in more traditional mutual funds and ETFs.
And instead of choosing an ESG fund that may invest in companies not aligned with your values, or in sector screening funds that exclude industries you object to, you might instead want to look for narrowly focused impact funds that align with your vision of a better world. Such as funds that only invest in companies with women or minorities as their CEOs. Or those that aggressively champion diversity and gender equality.
If you decide to hire a fee-only fiduciary investment adviser to help you select these funds, look for those who have experience helping women implement their own values-based investing strategies.
More importantly, make sure any advisor you’re considering is fully committed to helping you develop an investment strategy that aligns with your unique beliefs. After all, advisors are human, too. They have their own belief systems, and some may not feel comfortable helping clients whose values are diametrically opposed to their own.
Pam Krueger is the founder and CEO of Wealthramp, an advisor matching platform that connects consumers with vetted and qualified fee-only financial advisors. She is also the creator and co-host of the award-winning MoneyTrack investor education TV series seen nationally on PBS.