A recent paper by two legal scholars warns of the absence of transparency, of the opacity, that investors may face in ESG funds and ESG exchange-traded funds.
“Buyer Beware: Variation and Opacity in ESG ad ESG Index Funds,” is the work of Dana Brackman Reiser and Anne M. Tucker, who are affiliated with Brooklyn Law School and Georgia State College of Law, respectively.
They argue that high-net-worth investors at least generally get the ESG for which they are willing and able to pay. High-niche ESG brands “have more ESG-differentiated holding and voting records” than the lower fee generalist ESG funds. That is not a surprising conclusion, but it does warrant a look at the particulars of the study.
Depending on the Indexes
The Reiser-Tucker discussion of passive ESG observes that funds appealing to investors who want to take enlightened, sustainable, views on the environment, society, or corporate governance that are now coming online are designed to “track fledgling indexes of leading ESG companies, offering investors a lower cost and seemingly less risky alternative to active management while still pursuing environmental, social and governance excellence.”
These funds currently constitute roughly a third of the sustainable funds market, the authors add, referencing Morningstar.
This market depends largely on specially crafted ESG indexes. By way of example, the iShares MSCI USA ESG Select ETF tracks an optimized index which, according to MSCI, is “designed to maximize exposure to favorable [ESG] characteristics, while exhibiting risk and return characteristics similar to the MSCI USA index.” Investors can also choose to purchase MSCI products that involve passive screens. For example, the index behind the iShares MSCI KLD 400 Social ETF screens out companies with significant involvement in alcohol, tobacco, gambling the marketing of firearms to civilians, nuclear power, nuclear weapons, other controversial weapons, “adult” entertainment, and GMOs.
Opacity and Proxy Votes
Unfortunately, Reiser and Tucker continue, the whole idea of ESG ETFs is difficult as it inserts the index providers into the investment process. Their intensely important role is one they are tempted to keep opaque. Inserting them into the EG investing process “increases its complexity and opacity for investors.”
The field is opaque for other reasons as well, such as the “fluid definitional boundaries.” Beyond that broad meanings associated with each of the three letters, E, S, and G, there is little agreement about what counts as the sort of company an index should track, and so the sort of index a passive fund should track. The authors use the analogy of the word “success.” Funds might (If they were allowed!) be tempted to start naming themselves variants of the “Success Fund.” Investors might be drawn to that label. But a particular fund may or may not achieve investment success, and an index may or may not accurately convey the results of the underlying “success” companies.
The vague definitions in use by indexers and funds alike, Reiser and Tucker say, “suffice to meet funds’ securities law disclosure obligations, but leave investors without a clear understanding of how ESG investing will be practiced by a particular fund and make it difficult to compare across offerings.”
They find evidence, too, that “some ESG fund sponsors and managers are not as committed to the pursuit of ESG performance as their branding suggests.” This is especially the case when the funds cast votes in the course of equity battles with ESG significance. Behind the existing opacity, the managers can vote as they deem best on such issues, and investors would have to be “extraordinarily diligent” to learn about it.