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Here, we’ll review the best ESG ETFs, so you can find the right ones for you.
What is ESG investing?
Environmental, social, and governance (ESG) investing adds factors such as greenhouse gas emissions and corporate governance to the investment process. ESG investing is also known as sustainable, socially responsible, and impact investing.
ESG investing is not just about aligning your financial goals with your values. Studies show that ESG investing can reduce volatility and improve returns. The old perception that you had to sacrifice returns to do good has been largely debunked. In fact, ESG funds did better than the broader market during the stock volatility surrounding the coronavirus pandemic.
What are ETFs?
- Exchange-traded funds (ETFs) allow you to buy many stocks or bonds at once
- ETFs trade on exchanges like stocks, so you can buy or sell them during market hours
- The stocks or bonds in an ETF generally track an index. For example, if you buy shares of an ETF that tracks the S&P500, you are buying shares of the 500 companies that the S&P500 tracks. (ESG ETFs track indices that follow companies with sustainable practices)
- ETFs give you exposure to a set of companies without having to purchase individual stocks, which would be costly and time-consuming
- You can buy ETFs through a traditional brokerage, or a trading app. You can use a taxable investment account or a tax-advantaged IRA. ETFs do not have a minimum amount you need to invest
- Online robo-advisors such as Betterment will buy and sell ETFs for you for a small annual fee, typically of 0.25-0.50% of the assets you invest
ETFs vs. mutual funds
Both ETFs and mutual funds hold a collection of stocks or bonds, but they are traded differently.
ETFs are easier to buy and sell
- Unlike mutual funds, ETFs trade on exchanges like stocks. You can buy and sell them through your broker or app during market hours
- Mutual funds price once a day, and you can buy or sell them through a broker or directly from the issuer. There is a minimum you must invest ($2,500 is common), and sometimes they charge extra fees
ETFs are generally cheaper and more tax-efficient
- On average, ETFs have lower fees than mutual funds, though there are some exceptions
- For tax reasons, mutual fund costs are higher than ETF costs. If you invest in mutual funds, higher costs are passed on to you in the form of higher fees. (A mutual fund needs to redeem shares each time an investor sells. The remaining investors must bear the resulting tax liability. ETFs trade through and exchange and do not need to redeem shares each time an investor sells)
ETFs are generally more transparent
- Most ETF holdings are available daily, so you always know what you own
- Mutual funds holdings are generally released quarterly or monthly
Despite the advantages of ETFs, there are still many more ESG mutual funds than ETFs. This is particularly true for ESG funds. Mutual funds give you more options. Also, some 401k plans exclusively offer mutual funds.
With mutual funds, you also get the expertise of fund managers who spend time analyzing ESG data. In contrast, passive ESG ETFs use ESG scores from a third party that can vary significantly depending on the provider.
Finally, mutual fund managers can work with the companies to improve ESG-related disclosures or encourage them to set climate goals. On the other hand, passive ETFs are usually sponsored by giant asset managers that don’t typically engage with management teams.
How to evaluate ESG ETFs
Investing in ESG ETFs is one of the easiest and cheapest ways of investing sustainably. However, ESG ETFs are relatively new, and some of the funds are too small and expensive.
What should you look for when choosing an ESG ETF?
Assets under management (AUM)
Assets under management are the total value of the investments an ETF holds, or essentially the size of an ETF. Funds with more assets under management are generally considered lower risk.
ETFs are a competitive market, and some of the smallest ETFs don’t make enough money in fees to survive. Recently, the largest ETFs have been attracting assets, while smaller ETFs have generally been losing capital. Over 80% of ETF assets are now managed by giant asset managers BlackRock (iShares ETFs), Vanguard, and State Street (SPDR ETFs).
No one wants to invest in an ETF that shuts down. You won’t lose your entire investment if an ETF fails, but you may have to jump through time-consuming administrative hoops to get your money back.
You should be careful with smaller ETF managers with less than $100 million in assets. To help you assess an ETF, you can turn to online sources like ETF.com, which estimates the risk of closure for most ETFs using FactSet’s ETF Closure Risk tool. The tool looks at factors such as fund flows, assets, and if the manager has closed other funds.
ETFs charge fees – known as expense ratios – to cover administrative expenses. Expense ratios are the cost of owning ETFs. A 0.50% expense ratio will cost you $50 on a $10,000 investment each year and more over the years due to the compounding effect. Fees eat into your returns, and ETFs with lower expense ratios are better, all else being equal.
ESG ETFs are smaller, newer, and more expensive than conventional ETFs, though fees are declining. Some of the biggest ESG ETFs, such as iShares ESG MSCI USA Leaders ETF (SUSL), cost only 0.10%, on par with traditional funds.
When you buy an ETF, you pay a price higher than the quoted price, and when you sell, it’s at a lower price. The difference between the price at which you buy and the price at which you sell is called the bid-ask spread. When the bid-ask spread is large, it can eat into your return.
Spreads can be helpful when comparing similar ETFs. Bid-ask spread is not an issue for large ETFs that trade a lot, but some ESG ETFs are small and don’t trade much. The bid-ask spread is large and can decrease your gains. Spreads can be helpful when comparing similar ETFs; be wary of spreads greater than 0.10%.
Spreads do not include the brokerage commission you may need to pay. Fortunately, more brokers are now offering free trading.
Active vs. passive ETFs
Most ETFs are passive, meaning they track an index and replicate its returns. However, recently a few active ETFs have been launched. Active ETFs are managed by a portfolio manager who picks investments, just like most mutual funds.
Active ETFs try to beat their benchmark and charge much higher fees for the potential for more gains. Expense ratios over 0.50% are the norm with active ETFs. For example, Gabelli Love Our Planet & People ETF (LOPP), an active ETF, charges 0.90%.
Further, these funds are not transparent, so you may not know their daily holdings.
Historically, passive funds have outperformed actively managed funds after fees, so paying more for an active ETF may not be worth it.
Diversification of the ETF’s holdings
Before buying an ETF, you should understand what the ETF owns and how concentrated its holdings are. Some funds are more diversified than others.
You can start by looking at the top ten holdings. If you are looking for diversified market exposure, an ETF with most of its assets in the top ten holdings is not suitable for you. It will be much more volatile, and you will be buying its top ten or even top five stocks.
Thematic and niche ETFs are less diversified than ETFs that try to replicate the broad market. For most of the largest passive ESG ETFs, the top ten holdings are between 20% and 30% of assets, and they own hundreds of stocks. But there are also ETFs like Global X Lithium & Battery Tech ETF (LIT). LIT has 40 investments, and the top ten represent over 50% of its assets.
Ownership of fossil fuel and other controversial stocks
Most large passive ESG ETFs that track the market own some fossil fuel companies. They promise to deliver performance similar to the market, which includes energy companies. So they pick “best in class” fossil fuel companies.
Even some ETFs marketed as “fossil fuel reserve free” continue to own oilfield services companies (that do not own oil and gas reserves).
If you want to exclude stocks related to fossil fuels, run the ETF through a screener from Fossil Free Funds.
You can also check ETFs for investments in other types of companies that may not align with your values. The Invest Your Values tool from the nonprofit As You Sow offers ETF screens for deforestation, guns, tobacco, and weapons.
Types of ESG ETFs
U.S. stock ETFs
One of the best ways to get started with sustainable investing is to buy an ESG ETF that tracks a portion of the U.S. equity market. For example, the classic “60/40” portfolio recommends a balanced portfolio with 60% of assets allocated to stocks and 40% to bonds. The traditional broad market ETFs or mutual funds that make up 60% of the stock portion can be replaced with an ESG fund.
The largest U.S. equity-focused ESG ETFs track broad market indices like MSCI World or S&P 500, but they exclude companies with low ESG scores. Instead, these funds buy more “best in class” companies. They also exclude companies connected to problematic sectors like tobacco and weapons. (Fossil fuels are generally not excluded, though total energy exposure is reduced vs. conventional funds).
ESG scoring methodology varies from one fund to another, but most big ETF managers rely on data from index providers MSCI and FTSE. So, when you buy most large ESG funds, you buy what MSCI or FTSE say is sustainable.
Passive ESG funds tend to be among the cheapest to own and trade. All U.S. funds listed below have over $2 billion in assets and expense ratios between 0.10% and 0.25%, similar to conventional ETFs.
Some of the most popular ESG exchange-traded funds are:
iShares ESG Aware MSCI USA ETF (ESGU)
- Expense ratio: 0.15%
Launched in 2016, ESGU is one of the cheapest and most liquid ESG ETFs. The fund was designed to give you broad and diversified exposure to the U.S. stock market. As an ESG fund, it gives more weight to companies with high ESG scores, as defined by MSCI. Tobacco and weapons companies are excluded, though oil and gas companies are not. Like other ESG ETFs, the fund has a lot of exposure to tech companies.
Vanguard ESG U.S. Stock ETF (ESGV)
- Expense ratio: 0.09%
Launched in 2018, ESGV is more diversified than other ETFs on this list. It invests in around 1,500 small, mid and large-cap U.S. stocks. ESGV is the largest ESG ETF that excludes companies that own fossil fuel reserves. The stocks are screened based on the ESG criteria set by the index provider FTSE. Industries such as adult entertainment, alcohol, weapons, gambling, and nuclear power are also excluded. Key sectors are tech, financials, and healthcare.
iShares MSCI USA ESG Select ETF (SUSA)
- Expense ratio: 0.25%
Launched in 2005, SUSA is the oldest ESG ETF. SUSA invests in mid and large-cap U.S. companies with best in class ESG scores as defined by MSCI. Tobacco and firearms are excluded. SUSA is more selective than other ESG funds, with around 200 holdings. Tech and healthcare are the top sectors, and SUSA still has exposure to fossil fuels. SUSA costs 0.25% annually.
iShares MSCI KLD 400 Social ETF (DSI)
- Expense ratio: 0.25%
Launched in 2006, DSI tracks the MSCI KLD 400 Social Index, which is composed of 400 companies with the highest ESG scores in each sector. The index excludes alcohol, tobacco, gambling, weapons, nuclear power, adult entertainment, and GMOs. DSI still invests in fossil fuel companies. This ETF has a 0.25% expense ratio, which is not too bad, but higher than some of its peers.