Environmental, Social, and Governance (ESG) ETFs
ESG exchange-traded funds (ETFs) give investors a way to invest in issues that are important to them. These ETFs incorporate environmental, social, and corporate governance considerations into their investment approach.
What is ESG?
Environmental, Social, and Governance (ESG) is the umbrella term Schwab uses to describe various investing approaches that focus on social, environmental or corporate governance factors rather than solely risk and return.
The financial industry uses many different terms to describe these approaches to investing, and ESG has become one of the most widely used. When we refer to ESG, we mean it to encompass investing approaches that specifically use the term ESG, but also those described as "values-based investing," "impact investing," "sustainable investing," and other approaches.
Common approaches to ESG include:
This approach, also called negative screening, focuses on excluding certain companies, such as those that derive revenues from alcohol, tobacco, or firearms, from a portfolio. It appeals most strongly to investors who want to avoid investing in companies that don't align with their values.
An integration approach attempts to improve the portfolio's risk/return profile by considering ESG risks and opportunities in the investment strategy along with other material factors. In this approach, portfolios are constructed by investing in companies that score well on material ESG issues that are important to a specific sector.
This approach refers to explicitly deploying investment dollars in an effort to directly achieve a measurable outcome. Impact investors are typically interested in making a difference in the world or environment through the companies in which they invest.
Typical investment portfolio exclusions from ESG portfolios include tobacco, alcohol, weapons, and gambling.1
Common approaches to ESG integration and impact investing, targeting companies that are doing "good," include:
- Climate change: Investing in companies that are fighting climate change.
- Natural resources: Investing in companies that are preserving clean air and water, promoting responsible forestry, etc.
- Pollution and waste: Investing in companies that are reducing or eliminating pollution and waste.
- Human capital: Investing in companies that are hiring and training disadvantaged populations.
- Corporate governance: Investing in companies with strong governance, such as clean accounting.
For investors who care strongly about ESG issues, these funds can be an attractive investment. As you should with non-ESG investments, you should consider the quality of the ETF—its costs, risks, performance potential, and the experience of the investment team. Then you should consider how the vehicle's stated objective and strategy aligns with your ESG preferences by further examining the ETF's holdings.
View a list of ESG funds available at Schwab.
What are the pros and cons of ESG ETFs?
As you make decisions about your portfolio, it's important to understand what ESG ETFs can offer and what to watch out for.
As is the case with any ETF, ESG ETFs can help diversify an investment portfolio when mixed with other asset classes.
Broad array of investments.
ESG ETFs are available in over 40 Morningstar categories, but the majority are in equity asset classes, such as domestic, international, and sector equity.
Since most ETFs provide daily disclosure of their holdings, investors are able to see exactly which securities are held by the ETF each day. This enables investors to align their investments with their ESG preferences.
Lack of customization.
Investors often do not have the ability to customize an ETF's portfolio holdings to exclude securities that may conflict with their values.
Limited fixed income options.
While fixed income is a growing asset class for ESG, fixed income ETF choices remain more limited than equity asset class choices.
As the investing public has grown more interested in ESG, some portfolio managers have begun to talk about ESG aspects of funds that formerly were not described in those terms. In some cases, the degree of ESG focus in the fund is minimal and describing such funds as ESG is known as "greenwashing." Signs that indicate an ESG fund may be greenwashed include:
- Very weak references to ESG factors in the fund's investment objective and description.
- A fund that had no references to ESG in recent years suddenly adding in ESG terminology to the fund documentation or prospectus.
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