Should you invest in Vanguard’s new ESG Funds?
Vanguard’s History
Vanguard.com is one of my favorite options for DIY-investors. Their interface is easy to use and the company itself was founded by the late Jack Bogle, who was known as the “father of index investing”.
Mr. Bogle conducted a study for his undergraduate thesis at Princeton University in the 1950’s. He found that while active mutual funds aimed to beat broad market indexes, such as the S&P 500 Index, most perform worse over the long-term, especially when you take into account their high fees.
Mr. Bogle had just started Vanguard in the mid 1970’s when he saw an article by Paul Samuelson, a Nobel-prize winning economist, in the Journal of Portfolio Management. Mr. Samuelson conducted his own research and came to the same conclusion - the majority of stock pickers don’t beat their comparable market index. Instead, he wrote, someone needed to set up a low-cost investment fund that tracked the S&P 500 Index. That gave Mr. Bogle the confidence to do just that, and the first index fund was launched. Decades of research and independent studies have validated what these two men discovered and trillions of dollars have since flowed into these so-called “passive” strategies. 2019 marked the first time that the amount of money in passive strategies surpassed the money in active strategies.
Vanguard’s New ESG Funds
ESG and impact investing also continues to gain traction as an increasing amount of research is highlighting the financial and non-financial benefits of adding this additional layer of due diligence to the investment process. So it was no surprise when Vanguard entered the ESG landscape with 3 new ESG exchange-traded funds (ETFs). Given my immense respect for Vanguard and knowledge of the benefits of ESG integration, I was excited to review Vanguard’s ESG index funds.
Vanguard’s New ESG Index Funds
Vanguard ESG U.S. Stock ETF (ESGV) - .12% expense ratio
Vanguard ESG International Stock ETF (VSGX) - .15% expense ratio
Vanguard ESG U.S. Corporate Bond ETF (VCEB) - .12% expense ratio
Unfortunately, after my research, I concluded that Vanguard’s new ESG index funds are not the best option available for investors looking to integrate ESG factors into their investment process. It is, however, a great opportunity to highlight “why” and understand how two funds with “ESG” in the name can be very different.
Evaluating ESG Funds
No two ESG funds are the same. While some critics highlight this reality as a reason to dismiss ESG investing, the same argument could be made against target-date funds.
If you compare two Target-Date 2045 funds, which are created for individuals retiring in the year 2045, you will find they are very different. Some target-date funds have exposure to REITs and commodities; others don’t. Allocations, glide-paths and costs vary greatly. Despite that difference, target-date funds are an absolute necessity. Before target-date funds were prevalent, I witnessed investors leaving their 401k money in cash, or allocating equal percentages to every single fund available, or implementing other strategies that quite frankly, made no sense, simply because they had no education on personal finance. Target-date funds encourage people to invest by reducing inertia and they provide at least some level of diversification and risk mitigation.
Because no two target-date funds are the same, an extra layer of due diligence is required to ensure you are choosing the best target-date fund available. This extra layer of due diligence is also required with ESG funds. If you are one of the growing number of investors that are convinced of the benefits of ESG investing, that is the first step. The next step is to look under the hood to decide which ESG fund to invest in.
ESG Investment Approaches
Vanguard’s new ESG index funds employ negative screening.
Negative screening can also be referred to as exclusionary or avoidance screening. This is a practice where companies, industries, sectors, or countries that are seen as unfavorable or out of alignment with basic societal values are removed from the portfolio (or given a reduced weighting).
First, Vanguard’s ESG index funds start with the traditional, parent index. Next, they apply a negative screen as listed on their website.
Excludes companies that:
Produce alcohol, tobacco, gambling, and adult entertainment.
Produce civilian, controversial, and conventional weapons.
Produce nuclear power.
Do not meet certain diversity criteria.
Have violations of labor rights, human rights, anti-corruption, and environmental standards defined by UN Global Compact Principles.*
Own proved or probable reserves in fossil fuels such as coal, oil, or gas.**
*For more information, go to unglobalcompact.org/what-is-gc/mission/principles
**This also excludes any company that FTSE determines has a primary business activity in: (a) the exploration and drilling for, as well as producing, refining, and supplying, oil and gas products, (b) the supply of equipment and services to oil fields and offshore platforms, (c) the operations of pipelines carrying oil, gas, or other forms of fuel, (d) integrated oil and gas companies that provide a combination of services listed in (a)-(c) above, including the refining and marketing of oil and gas products, or (e) the exploration for or mining of coal.
In comparison to another ESG index fund, the iShares ESG optimized funds utilize a combination of negative screening and tilting.
The iShares ESG Optimized funds have a multi-level process. Similar to Vanguard, they start with the traditional, parent index. Next, they apply a negative screen to remove the following:
Civilian firearms and controversial weapons.
Tobacco
Thermal coal and oil sands.
Companies with severe controversies
Finally, within stated constraints to reduce tracking error to the parent index, the ESG index is constructed by assigning higher weight to companies with higher ESG scores and lower weight to companies with lower ESG scores. Here are some examples of ESG factors that may influence a company’s weighting:
Environment (E): Whether or not a company has invested in technology, which an impact future costs, water use, and their reliance on fossil fuels.
Social (S): Whether or not a company has established protocols to monitor and prevent predatory sales practices, which can affect reputation risk and potential lawsuits.
Governance (G): Whether or not a company splits the role of CEO and Chairman, which can promote independence and affect company performance.
ESG Options for Vanguard Investors
It is disappointing that Vanguard’s new ESG index funds are simply applying a negative screen. They are not considering ESG scores and factors at all.
Research shows that negative screening alone can lead to higher risk and lower return. This is not the case with ESG integration - research is showing the risk-adjusted returns are on average the same, if not better, than traditional investing.
If you are a Vanguard investor and are interested in ESG integration, rather than utilize Vanguard’s ESG Index funds, consider evaluating the iShares ESG Optimized Funds.
iShares ESG Optimized Funds (available commission-free at Vanguard.com)
iShares MSCI USA ESG Optimized (ESGU) - .15% expense ratio
iShares MSCI USA Small-Cap ESG Optimized (ESML) - .17% expense ratio
iShares MSCI EAFE ESG Optimized (ESGD) - .20% expense ratio
iShares MSCI EM ESG Optimized (ESGE) - .25% expense ratio
iShares MSCI US Aggregate Bond ESG Optimized (EAGG) - .10% expense ratio
Learn More
Seeing “ESG” in a fund’s name is not sufficient. You need to dig deeper, conduct your own due diligence, and work with someone who is familiar with the nuances associated with impact investing. For additional learning, check out this podcast episode that goes into detail on MSCIs methodology as it relates to ESG ratings.
Linda Rogers, CFP®, EA, MSBA is the owner and founder of Planning Within Reach, LLC (PWR). Originally from New Jersey, Linda services clients throughout San Diego county and nationwide. She leads the design of PWR's investment portfolios which utilize broad, low-cost investments that integrate environmentally, socially, and governance (ESG) factors.
Planning Within Reach, LLC (PWR) is a fee-only and fiduciary wealth management firm offering one-time comprehensive financial planning, ongoing impact-focused investment management and tax preparation services in San Diego and nationwide. PWR is a woman-owned firm that specializes in busy professionals and impact investors. Planning Within Reach, LLC and their advisors do not receive commissions and do not hold any insurance licenses or brokerage relationships.