Do-Good Investors: Watch Out For What These Funds Hold

If you listen to the marketing hype, assets devoted to ESG—industry jargon for investments sensitive to environmental, social and governance issues—account for some $8.7 trillion, double the amount just five years ago. That's great news for the planet, right? Not so fast. Much of the growth is a matter of semantics. What were once run-of-the-mill value or growth funds are being reclassified as sustainable or ESG-friendly.

Take, for example, American Century's $227 million Sustainable Equity Fund. In 2004 it launched with the name Fundamental Equity, focusing on large companies. Last year the frequent underperformer was renamed to meet growing investor demand for sustainable investing. Says portfolio manager Joe Reiland, "We all want to preserve the environment and do well and do good."

Even more rampant than shape-shifting funds are those with liberal definitions of what qualifies as ESG. Take the two largest asset managers in the world, BlackRock and Vanguard. Both have ESG funds with holdings that defy what many might consider socially responsible. BlackRock's MSCI KLD 400 Social ETF holds McDonald's, ConocoPhillips and Occidental Petroleum, even though McDonald's has struggled with ongoing labor disputes and many ESG funds steer clear of companies that hold fossil-fuel reserves. BlackRock declined to comment on specific holdings.

Vanguard's SRI (socially responsible investing) European Stock Fund counts British American Tobacco and Royal Dutch Shell as top holdings. "That's terrible. ... a travesty," says Jerome Dodson, manager of $4.9 billion (assets) Parnassus Endeavor, a strict ESG adherent with a stellar 12.4% ten-year average annual return. Mark Fitzgerald, Vanguard's head of equity products in Europe, says the fund uses higher-level screening criteria like respect for human rights instead of taking a more granular approach.

American Century's rechristened Sustainable Equity fund overhauled its portfolio using data from MSCI's sustainable-investment research arm and Sustainalytics. It sold stocks like ExxonMobil. "It's not really a leader amongst peers in terms of climate change," says Reiland. Yet it held on to ConocoPhillips and bought Marathon Petroleum. The fund also kept cigarette merchant Philip Morris International because, Reiland says, the company is promoting e-cigarettes. Real reason: "Every financial study showed we would have better performance including Philip Morris," he says.

Ave Maria, a $2 billion money manager, screens out companies that don't comply with the values of the Catholic Church—firms that contribute to causes affiliated with abortion, and even hotels, because they rent adult films. But some sin stocks have Ave Maria's blessing. Its Rising Dividend Fund owns Hexcel, which makes fighter jet parts, and liquor maker Diageo. "Jesus' first miracle was turning water into wine," says portfolio manager Brian Milligan.

According to Yale professor and sustainability expert Daniel Esty, part of the problem is flawed data and a lack of standardization. For greenhouse-gas emissions, some companies report only the emissions of their own facilities, while others add in their supply chain's emissions. Few people understand this nuance, so those that report more diligently look worse.

Some funds like CGM Focus get high rankings for sustainability even though it's not their mission at all. Given the surge in interest in ESG, don't be surprised if "sustainability" soon joins P/E and EPS growth as a key fundamental measure of a company's worth.

Socially Irresponsible? 

Here's a sampling of funds with eyebrow-raising holdings.

*Assets under management (AuM) are in millions of dollars. YTD returns are net of fees.

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