ESG funds: boost your portfolio with green investing

I’m delighted to introduce the first guest post on this site. The Financial Independence Campaign blog is relatively new but already packed with really informative and entertaining articles about all things financial independence, so if that sounds good do head on over.

ESG funds (Environmental, Social and Governance equities funds) have shown better returns in many cases than traditional index funds.  For example, the FTSE Russell Global All Cap Choice Index has shown a 12% higher return for investors over the last five years than its non-ESG counterpart, the FTSE Global All Cap Index.

That’s right: it pays to be green.

Here’s how to look at picking ESG funds as part of a financial independence equity portfolio.

What are ESG funds and SRI funds?

ESG funds are usually screened funds.  That means that they generally take an existing index, like the FTSE 100 or the S&P 500 or something else that’s famous, then get rid of the companies in it that don’t meet the fund’s screening criteria.

Not all ESG funds are created equal.  Some will get rid of fossil fuels, weapons, adult entertainment, gambling, tobacco and alcohol.  Others will simply exclude controversial weapons and oil stocks.  Depending on what you’re against investing in, there will be the right ESG screening criteria for you.

In fact, there are over 1,000 different ESG indices.  Here’s a cool link to environmental-finance.com that gives you access to a broad library of ESG indices that you can choose from.  Whatever your focus, there will be one for you.

SRI funds are a little different.  Socially Responsible Index (SRI) funds choose their investments based on how well they perform against ESG criteria.  A good example is the MSCI SRI World Index, which heavily weights companies that perform well in MSCI’s ESG ratings and ignores companies that don’t comply.  This is almost like creating a whole new index instead of refining one that already exists.

Typically, as a result, SRI funds are stricter than ESG funds.  It’s just a label though, and you should look at what each fund specifically invests in before you choose one.  There’s nothing to force a fund manager to use this label the same way as another fund manager would, so not all funds are created equal.

Why should we care about green investing?

Companies exist to make money for shareholder.  That’s it, by the way – they’re only as good or bad as the shareholders want them to be.  Their entire existence is to please shareholders.  Shareholders need to approve a lot of the big decisions of the board and shareholders have the right to kick board members out of office.

With index funds, you don’t get the ability to vote, it’s done for you by the fund managers.  However, if your company is mostly owned by an ESG fund, you’d be a foolish CEO to choose to act against environmental, socially responsible or green principles.  Your very job might be on the line.

This seems too good to be true – and in reality, it’s a bit more complicated.  Companies are usually funded directly by shareholders when they start up.  This is called the primary market.  Index funds and retail investors don’t usually get involved until a company floats on the stock market and these shares are sold second-hand on the market – called the secondary market.  Your share purchases won’t change a company straight away, but if the secondary market is only interested in buying the shares of green companies, the primary investors will be less willing to invest in non-green companies.  You can’t turn a profit as a primary investor unless you can sell your shares later.

The more that people invest in ESG funds, the more ESG capitalism becomes.  It’s as simple as that.

Doesn’t ESG investing cost me more?

Actually, no.

ESG funds have traditionally put off “serious” investors because they were supposedly less we;; diversified than regular index funds, as they were often actively managed funds and therefore consisted of a smaller selection of actively picked shares.  This made them higher risk than other index funds, and because they generally don’t invest in fossil fuels and vice industries that makes them less diversified across industries.  This meant that they looked like they had a higher concentration risk and this was a turn-off for ESG funds compared to cheap and cheerful global indices.

It also didn’t help that a lot of early ESG funds had a higher Ongoing Charges Figure (i.e. fee) than their non-ESG counterparts.  That’s still slightly true, but the difference on modern funds can be less than a quarter of 1%, which is a small price to pay considering that they have been performing better than the normal global indices.

Here’s a cheeky comparison chart of fees that I’ve put together on three common ESG funds:

ESG FundOCFClosest “Normal” equivalentOCFDifference in fees
Vanguard ESG Global All Cap UCITS ETF (V3AM)0.24%Vanguard FTSE All-World UCITS ETF (VWRL)0.22%0.02%
iShares MSCI World SRI UCITS ETF (SGWS)0.23%iShares Core MSCI World UCITS ETF (IWDG)0.30%0.07% (SRI fund is actually cheaper)
Xtrackers MSCI UK ESG UCITS ETF 1D (XASX)0.18%iShares MSCI UK UCITS ETF (CSUK)0.33%0.15% (ESG fund actually cheaper)

In two cases, the ESG funds were cheaper than their non-ESG counterparts.  In the other, the difference was two hundredths of a percent.  

I think that answers our question: a little bit of green investing doesn’t cost you more.

Performance 

Green capitalism is one thing, but if you’re already aware that investing is like voting with your money, you won’t need convincing about the benefits of ESG funds.  I’m not going to preach to the choir on a blog about sustainable financial independence!

The bit you’re really interested in is how ESG Funds stack against their non-ESG regular counterparts.  How much does it actually pay to be a green investor?

I looked at those three index funds above and compared the returns for the last 5 years in the table below:

ESG Fund5YR Closest “Normal” equivalent5YRDifference in return
Vanguard ESG Global All Cap UCITS ETF (V3AM)107.40%  (based on historical index data)Vanguard FTSE All-World UCITS ETF (VWRL)90.68%16.72%
iShares MSCI World SRI UCITS ETF (SGWS)103.50% (estimated from historical index data)iShares Core MSCI World UCITS ETF (IWDG)93.48%  (based on unhedged SWDA 5YR)10.02%
Xtrackers MSCI UK ESG UCITS ETF 1D (XASX)38.01%iShares MSCI UK UCITS ETF (CSUK)29.66%8.35%

So, based on 5 year returns, it seems that ESG funds and green investing actually does pay off.

OK, you got me – this isn’t a fair assessment

There are a few limits to this theory.

  • Theoretical returns:  two of these three ESG funds were less than 5 years old, so the data used is from the benchmark indices (FTSE Russell and MSCI provided the data).  This isn’t the same, doesn’t include the OCF etc. and generally assumes that a fund perfectly matched the index.  They usually don’t.  Still, the difference would only be smaller, not eliminated, so it’s not that significant.
  • Historical data:  past returns are never a guarantee of future returns.  Investing is a risky business, the best you can do is assess probabilities.  However, what were the odds of all three showing such a big positive return for the ESG fund?
  • 5 year returns aren’t statistically significant:  despite every fund factsheet stopping at the 5YR point, 5 years isn’t that long in investing.  It’s barely enough to capture a few market cycles, but it’s the best I could get for a fair comparison.

Even with these limits on the method, though, it’s pretty clear: it pays to be green.  

Conclusions

ESG funds are now cheap enough for regular retail investors like you and me to buy.  The prices of index funds using ESG and SRI screens and selectors aren’t too different from “normal” index funds.  In some cases, they’re cheaper.

However, excluding fossil fuels and the more controversial investment classes seems to pay off.  All three of the ESG funds in this post performed significantly better over five years compared to their non-ESG equivalents.

I’ve said it before and I’ll say it again: it pays to be green!

SierraWhiskyMike is a guest blogger from the Financial Independence Campaign blog.  For disclosure and fair reporting: SierraWhiskyMike does have an investment position in one of the ESG funds listed.  

This is not financial advice and you should do your own research – don’t trust your future to some random on the internet!

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