Drawing Distinctions Between ESG ETFs And Impact ETFs

There are more than 100 US-listed ETFs categorized by Morningstar and others under ESG (Environmental, Social, and Governance). All have an element of attempting to align investments with personally held social values. Under the hood, there are huge differences between many and subtle huge differences between others.

The Investment Company Institute uses three buckets for ESG mutual funds and ETFs, as follows:

  1. ESG inclusionary - refers to funds that use ESG information to select what stocks to include in their portfolios, such as companies with the highest ESG scores in their industry.
  2. ESG exclusionary - funds that eliminate stocks based on values, such as being fossil-free or “sin”-stock-free
  3. Impact investing - funds with a specific environmental, social or governance themes, such as green bond funds, diversity and inclusion, faith-based, resource preservation and/or clean energy funds.

These distinctions are useful for a generalized framework. However, as we will detail, all ESG ETFs use some inclusionary and some exclusionary criteria. The exclusions are based on quantitative metrics, values-driven exclusion criteria or a mixture of both. Most of them tend to be broad-based, market-capitalization-weighted, and intended as core-substitute or core-supplement. From a portfolio analysis perspective, the differences tend to be subtle and easily comparable. As with most core portfolios, institutions may evaluate them quarterly and annually to compare returns with expectations. In the past ten years, there has been evidence that ESG ETFs have enjoyed outperformance of the indexes that they use as selection universes. Recent papers indicate that the exclusion of companies with poor ESG metrics help performance and reduce standard deviation by avoiding companies more likely to suffer negative events such as lawsuits and public opprobrium that may result from backward-looking policies and practices. In other words, ESG data help portfolio managers mitigate event risks. Most, but not all, of the ETFs in this category have exhibited performance histories to support this premise.

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Disclosure: I am a Senior Advisor to ValuEngine. 

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