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Better ESG Rules, Better Clarity

More and more investors of all sizes and stripes have been turning to environmental, social and governance (ESG)-focused funds for their portfolios. And Wall Street has been happy to oblige. In recent quarters, there has been a surge of new ESG ETFs, mutual funds and other investment vehicles designed to cover various socially responsible investing (SRI) metrics and themes.

The problem is, one man’s ESG is another man’s closet index fund.

With no hard and fast rules on what constituents ESG or how investment managers make their decisions, some of the funds launched or relaunched have been less than ideal for investors. And there’s no real way to know what you’re getting with an ESG fund.

But that’s about to change.

The Securities & Exchange Commission (SEC) is finally getting involved and setting forth rules designed to protect investors. In the end, better rules will provide better clarity for our portfolios and only heighten ESG as a theme to base investments on.

Explore our ESG channel to know more about ESG strategies and trends.

An Oil Company in My ESG ETF?

As investors, we understand that when we buy a “value” fund what we are getting ourselves into. Same with growth or small-cap stocks. The reason being is that the SEC has developed rules defining what these terms mean and how asset managers can use them in their marketing and fund names. You can’t call your fund a value fund if your managers own high P/E growth stocks or use the words target-date, if you don’t have a group of asset classes that follow some sort of glidepath through a certain time period.

For ESG, it’s still the wild west when it comes to fund names, disclosures and other investment criteria. That plays itself out in some interesting ways.

For example, the $21 billion iShares ESG Aware MSCI USA ETF (ESGU), which bills itself as a fund “with favorable environmental, social and governance (ESG) practices”, actually owns oil and fossil fuel names. This includes Exxon Mobil (XOM) and ConocoPhillips (COP). ESGU isn’t alone in that ownership. The BlackRock U.S. Carbon Transition Readiness ETF (LCTU) also owns fossil fuel companies. Several wind and solar power-focused ETFs also own global oil/fossil fuel names as firms like BP (BP) and France’s Total (TTE) as they are some of the largest owners of wind and solar farms in the world.

Meanwhile, many ESG funds have been so-called converted funds or closeted-index trackers. These are either money losing funds that Wall Street puts an “ESG” spin on to raise assets or simply track the S&P 500 in roughly the same proportion as many members of the benchmark meet ESG screening criteria.

For investors, this poses a huge problem. If you’re looking at environmental factors for your portfolio, the last thing you’d think most people would want would be an oil company in their fund. Or at least they wouldn’t expect to find one. But because of some screening methodologies which rank stocks within sectors against each other rather than sectors versus sectors, we get fossil fuels, metals & mining and potentially other ESG landmines in a portfolio.

That’s where things get dicey with regards to ESG. Investors are expecting X when they are actually getting Y with regards to the labeling.

Use the Dividend Screener to find the securities that meet your investment criteria.

The SEC Comes to the Rescue

As part of a wide-sweeping regulatory change courtesy of the Biden Administration, the SEC is now taking a hard look at ESG labeling, screening and marketing issues.

SEC Examiners have started to send out letters to various fund and asset managers to gather information in painstaking detail on exactly what screening methods they use for funds that fall under ESG designations. This includes various information on ESG compliance programs, policies and procedures as well as statements made by managers in marketing material and regulatory filings. Additionally, the SEC is starting to compare the stricter European standards with the looser U.S. standards for ESG labeling.

This is now the second review into ESG mislabeling in less than two years by the SEC.

However, this time, the review may stick, giving the Biden Administration’s pro-Main Street tilt. Moreover, this time, the review is being done by the agency’s examinations division. This group is allowed to trigger policy changes as well as bring data to SEC’s enforcement unit for trials and fines. The SEC is finally getting serious about ESG, its labeling and how it affects investors and decisions.

Clarity Is Coming

With nearly $35 trillion in ESG and SRI assets under management, the SEC is certainly in the right when it comes to looking at sustainable investing. And right now, there are no hard and fast rules. The ESGU example of holding Exxon is a prime example of the confusion in the theme.

With such large amounts of assets and continued adoption by pensions, institutional and retail investors, The SEC is under pressure to build out ESG regulations and create a standard. Analysts and fund wonks expect the agency to act by the end of the year with such guidance.

Ultimately, that will be great news for you and me. For ESG to thrive and be a viable investing technique, we need to have a standard for what qualifies for the theme. By knowing what we are buying, why funds hold certain assets and what really fails under the ESG/SRI umbrella is vital to making an investment decision. Just like you wouldn’t buy a growth fund expecting it to hold deep value stocks, we expect a certain asset to be in an ESG ETF. With the SEC’s pending framework, we’ll get clarity on what that means.

In the end, it should boost assets more and make the technique adopted by more investors. All in all, it’s a win-win for our portfolios.

Click here to explore the portfolio management channel and learn more about different concepts.

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Oct 12, 2021