ESG index funds are hot. That may be a risky thing for investors

When it comes to investing, the notion that you can make money in the market and feel good about your investments at the same time is very compelling, especially among younger investors from the millennial and Gen Z demographics. This is the key reason why environmental, social and governance (ESG) screens are being more commonly used to evaluate stocks by fund managers — including the world’s biggest of all, BlackRock — and socially responsible investing is attracting more assets.

According to Morningstar, estimated flows into open-end and exchange-traded sustainable funds, the overall category of ESG and SRI funds, reached $13.5 billion through this past September. That’s not a huge number relative to the overall size of the fund industry — which is measured in the trillions of dollars — nor is it big compared to overall ETF flows, which have reached hundreds of billions of dollars annually in recent years. But it is a big jump from the $5.5 billion these funds attracted in all of 2018.

One short-term reason for increased interest: the year-to-date performance of many of these funds has been strong.

The Vanguard ESG U.S. Stock ETF is up over 27% year to date, through Nov. 13, according to Morningstar data, and that’s compared to an S&P 500 ETF return of over 25% —.a 2% performance edge for Vanguard. BlackRock’s iShares ESG MSCI USA ETF is up 25% year-to-date, matching the market. Why would the performance edge exist for the Vanguard ETF and some other ESG funds showing recent outperformance of the S&P 500? To answer the question, you have to look under the ETF’s hood.

The Vanguard ESG ETF has a 28% sector weighting to technology, which is significantly higher than the S&P 500 and iShares ESG fund’s roughly 20% weighting to technology stocks. The “large-blend” category that Morningstar puts these funds in has a 22% weighting to tech, on average. For investors in ESG funds where a tech weighting is higher than average, it’s an advantage right now but could be a bigger risk for investors than they appreciate.

I want to make one thing clear: I am pro-environment, pro-equal rights for women and minorities, and pro-LGBT rights. I don’t hunt, my wife won’t wear fur, and we would never buy a backyard set made with redwood. I am not against the socially responsible investing approach and I’ve told clients that if owning ESG funds is the only way you’ll stay invested, then it’s not a bad way to go. But as a fiduciary, it is important for me to be clear with investors about what they are buying.

Outperformance and underperformance always need to be examined. And there are two likely reasons why a fund could outperform its benchmark. Either by overweighting the outperforming sector, or by lowering the expense ratio. In the case of the recent strong run for some ESG funds, it looks like the answer is an overweight to the technology sector.

In some cases, ESG underperformance has been linked to not owning enough of tech’s big winners. The iShares MSCI USA ESG Select Social Index Fund is trailing the S&P 500 by 35% over the past 10-year period. Among notable stock market winners it does not own: Amazon. My basic point is that the more investors migrate to customized indexes rather than the primary core market indexes, the more they need to look under the hood at holdings.

As this slice of the stock market grows, so too has both the numbers and kinds of funds using an ESG approach. There are funds that focus on excluding fossil fuel companies, as well as funds that focus on gender and LGBT equality in the workforce. Take the Impact Shares YWCA Women’s Empowerment ETF, which is up about 26% year-to-date, according to Morningstar. Like the Vanguard ESG ETF, it has a 27% weighting to the tech sector. Another one is the InsightShares LGBT Employment Equality ETF, which is up 25%, in line with the S&P 500, and that makes sense since its weighting to tech is lower, at 21.5%, and near the Morningstar large-cap stock fund average of 22% tech.

Since technology has been a market leader, it makes sense that ETFs that are overweight tech stocks — meaning they have a higher percentage of holdings in tech than the S&P 500 index does — would beat the index.

You can make the case this just proves the viability of the sustainable investing methodologies. You could say that tech companies are at the forefront of ESG and SRI, which is why they stand out in these products. That’s always going to be open to debate.

Alphabet has faced worker walkouts for its handling of sexual misconduct claims against executives and just began a board review, while just this week Apple‘s new credit card was dinged with allegations of algorithmic gender discrimination. Amazon, meanwhile, has been criticized for years over the direct reports to Jeff Bezos being almost exclusively white and male.

Debating the latest headlines’ relevance to ESG analysis is not the point I want to make here. There is always going to be some degree of necessary compromises made when it comes to investing based on one’s ethics, and it goes above and beyond avoiding sin stocks, firearms manufacturers and meat processors. This week, some investors (and readers of the Wall Street Journal) were surprised to discover that fossil-fuel companies are included in many ESG funds that have been raking in assets.

If you use an ESG fund as your core equities exposure — as a replacement for an S&P 500 index fund, for example — that would avoid the stock concentration problem with tech I’ve outlined here. But if you are investing in an ESG fund in addition to a plain vanilla equity fund, or investing in more niche ESG strategies, such as ones focused on workplace equality or fossil-fuel free companies, there is a greater risk that you have more concentrated stock exposure without realizing it. One compromise investors cannot afford to make is duplicating exposure to widely held stocks across portfolios. My fear is that as young investors migrate to ESG funds they run the risk of duplicating exposure to some big stocks they already own in other core investments.

If you feel it is important to invest using an ESG or SRI approach, it isn’t a bad way to go. This category doesn’t have a long enough track record to either prove, or disprove, the thesis. What we know for certain is that like all investment strategies, no one approach outperforms forever, and when strategies do work, it’s as likely to be because of the external market environment as a fund’s unique objective. As long as the tech sector continues to lead the stock market higher, I’d expect this class of funds to continue to do well and attract more investors.

The key to investing in sustainable investment products is the same as any other – remove the emotional part of the decision — the “feel good” aspect in this example. Look at the underlying reasons why a particular strategy works to see if it is sustainable, and to see how it changes the risk equation for you. The hedge fund manager now considered the best stock picker of the modern era, Jim Simons, mathematician and founder of the super-successful hedge fund, Renaissance Capital, made his fortune removing emotions and biases from investment decisions as much as possible.

Feeling good about how you’re investing is a legitimate starting point, but it’s not an end unto itself. In fact, it may make looking under the hood of your preferred investment more important than ever. Over time, the ESG and SRI-focused funds will be important for investors to watch, especially in cases where expense ratios (the fees that investors pay to fund managers each year) are higher than on core equity funds. As more American corporations move toward meeting ESG and SRI metrics — as I noted BlackRock now does ESG screening across all of its funds — I think an ESG ETF differentiation factor may even disappear. But for now, let’s deal with what we know, and make sure that includes what a fund is actually holding.

—By Mitch Goldberg, president of ClientFirst Strategy, an investment advisory firm