On Greenwashing and Responsible Investment Management...
Used to describe the act of misleading consumers regarding the environmental practices of a company or the environmental benefits of a product or service.
Sorting through hype and decoding what marketers really mean when they try to sell their product is tiring! What does ESG (Environmental Social Governance) really mean when you put that label on your new exchange traded fund (ETF)? How about "Low Carbon"? Or how about this one: Conscious Companies. Impact anyone?
The bottom line is that there is only one way to truly know if an investment (mutual fund or ETF) is socially and environmentally responsible: Look Under The Hood - Check out what their holdings are.
And what do we see when we look under the hood? Well, sometimes the fund is the real deal - Great examples are Green Alpha, Parnassus and Green Century. We know these managers and they have a long history of investing with their values.
Many times, though, it's a horror show. I keep a running list of funds that, one way or another, identify themselves as being socially responsible, ESG, sustainable, impact or some other similar label.
I randomly selected a fund from this list, the American Century Sustainable Equity Fund (AFDIX). American Century is a big mutual fund company, and this fund is its only "sustainable" offering. It is described on their website as "The portfolio managers also take environmental, social and governance ("ESG") factors into account in making investment decisions." Let's take a look under the hood....
The top 25 holdings aren't egregious, but I don't really see anything that I would consider "sustainable" except for maybe Alphabet, Intel and Applied Materials. The next 25 holdings get more interesting, though: They include Dow Chemical; Philip Morris International; Northrop Grumman; Schlumberger and ConocoPhilips. A chemical company, a tobacco company, a defense contractor and two fossil fuel companies. And how many solar, wind or energy efficiency companies in their holdings you ask? Zero.
Let's try another fund: How about the FlexShares STOXX US ESG Impact Index Fund (ESG). This ETF is one of two "ESG" funds managed by FlexShares - this one being US focused and the other global. Just like the American Century fund, FlexShares describes this one as a "core equity holding with Environmental, Social and Governance (ESG) exposure in an effort to enhance risk adjusted returns." It also says the "index assesses US companies based on Key Performance Indicators (KPIs) in ESG categories." Let's lift the hood...
The first thing I see about this is that it looks almost exactly like the S&P 500 holdings. In it's top 25, I see a couple of good companies, Alphabet and IBM. I'm baffled to see Exxon Mobil and Chevron - two companies that should never have the word sustainability even in the same time zone. The next 25 holdings don't get any better: Schlumberger, Altria and ConocoPhilips - oil and tobacco. I will give them credit and say that Tesla is sandwiched in this group. The next 25 includes Duke Energy, Halliburton and Monsanto. Once again, there is very little in this portfolio would I ever call sustainable.
This kind of strategy is called "Best in Class," and it is greenwashing. It is creating a false relativity - compare one oil company versus another and determine which one is greener - neither are. This strategy just doesn't fly. Green architect and philosopher Bill McDonough says "being less bad is still bad."
And how can they justify investing in tobacco companies in funds that supposedly have social screens?
We subscribe to a service called Morningstar Direct. It's pricey, but I really get a lot of value from the data they provide, the lists I can create and the analysis engine. I use it extensively.
One feature of the service that I was very excited about when we signed up was their sustainability ratings. They rate funds and ETFs on a scale of one to five globes with five globes being the best. This would certainly help me with my due diligence right? Not so much.
Like the best in class strategy above, the Morningstar sustainability ratings are based on relatively between funds. They compare funds within categories to determine their ratings - which can be very misleading.
Let's look at an example: The Shelton Green Alpha Fund (NEXTX) is a five globe fund. I know all of the folks there, and they truly walk the walk. It's top holdings are Vestas Wind Systems, Pattern Energy Group and First Solar. It truly deserves its high sustainability rating.
The Invesco Energy Fund (FSTEX) is also a Morningstar five globe fund. It's a little different, however. Here's how it is described, "The fund seeks long-term capital growth by investing primarily in energy companies, which include oil companies, oil and gas exploration companies, natural gas pipeline companies, refiners, energy conservation companies, coal companies, alternative energy companies and innovative energy technology companies." After reviewing the holdings, there are no alternative energy companies - only fossil fuels.
How is it that one of the greenest, most sustainable funds out there has the same rating as a 100% fossil fuel fund? Category rankings. The Invesco Energy Fund is the "most sustainable" among all of the energy funds according to Morningstar. The two are simply not comparable and this error in Morningstar's rating system makes the entire rating system useless and dangerous.
Why is it useless? Because you cannot assign the same sustainability rating to FSTEX that you do to NEXTX. I cannot just rely on the globe ratings - I still have to look under the hood and see what each of the funds invests in.
Why is it dangerous? Picture this: A client meets with their traditional financial advisor at one of the big brokerage houses. The advisor is not an expert on socially and environmentally responsible investing, but the client ask their advisor to "green" their portfolio. The advisor goes to Morningstar Direct and picks out several Five Globe funds, relying on the quality of the Morningstar assessment. The client will think that they have a sustainable portfolio. But based on the above examples, who knows what they will really get.
Will they get the American Century fund from the first section that has five globes or the FlexShares fund that has four. Neither have sustainable holdings that are comparable to NEXTX, but the Morningstar system says that they are comparable. Perhaps the client will get the Invesco Energy fund. Will the client look under the hood for themselves? Probably not. And why would they - that's what they're paying their advisor for.
Bottom line is I believe that the Morningstar Sustainability Ratings are greenwashing. They allow a financial advisor to put together a portfolio of five globe funds for clients that have neither a sustainability mandate or even any sustainable holdings. As someone who lives and breathes responsible investing every day, this is unacceptable. Morningstar is risking its good name and reputation by continuing to sell this misleading rating system.
At the same time, it makes me feel good that we have put the time in to create a quality system of due diligence at Earth Equity Advisors. It's hands on - I review every holding in each fund - it's a lot of work but it is worth it. When a client buys into our portfolio models, they can have confidence that they truly own a sustainable and responsible portfolio. I'm proud of the work that we do and will continue to improve it.