Interest in ESG cools as focus on transparency heats up

Naughty or nice, a reckoning is coming.

As global financial regulators focus on the disclosure of environmental, social, and governance factors — both for public companies and investment products — the exchange-traded fund business has set itself up for certain attention.

According to FactSet Research Systems Inc., 231 U.S.-listed equity exchange-traded funds consider ESG factors in building portfolios. These ETFs, which collectively held $126 billion in assets as of June 8, range from broad-based funds with exclusionary screens, to narrower indexed and active funds incorporating ESG ratings and "sustainability," to funds focused on sectors, themes and even ESG laggards.

Ninety percent of these ETFs launched after March 7, 2016. That day, State Street Global Advisors kicked off the modern era of ESG funds with the launch of the SPDR SSGA Gender Diversity Index ETF (SHE). Then, to commemorate the one-year anniversary of the product's listing — and International Women's Day — SSGA scored a huge marketing win by unveiling the Fearless Girl statue, staring down the Charging Bull of Wall Street sculpture.

At launch, SHE's assets were boosted by a $250 million seeding investment by the $312.2 billion California State Teachers' Retirement System, Sacramento. Since then, other mission-driven pension funds and institutional investors have followed this lead, contributing initial assets to other ESG ETFs. (When institutional investors seed new ETFs, there are no financial terms between the investor and the issuer, nor is there an obligation to keep the assets in the ETF for any amount of time.)

While no ESG ETF has been as attention-grabbing as SHE and SSGA's Fearless Girl, winning multiple Cannes Lions awards for advertising, the recently proposed rules on fund names and disclosures likely have the bulk of the industry reconsidering the "ESG-ness" of it all. These include products designed to meet ETF investors' interest in climate, culture, diversity, and all things green or "responsible."

"As it stands now, ESG is amorphous, fluid and subjective," said Julien Bourgeois, partner with Dechert LLP in Washington. "Investors are entitled to full disclosure in understandable language. We need to find standards."

While some ESG ETFs make hay about their proxy-voting policies and disclosure, many investors are voting with their wallets. Alongside the recent equity market decline, ESG ETFs tracked by FactSet experienced one-month outflows of $1.7 billion, compared with $25.3 billion of inflows for the one-year period ended June 8. Only 25 of the 231 products hold over $1 billion in assets, while 96 hold less than $25 million.

Recent stock market volatility also highlighted the growth and technology bias in many ESG products and themes. Often excluded are carbon-intensive energy companies, sin stocks such as tobacco and gambling, as well as weapons manufacturers and defense contractors.

But the current news cycle has highlighted the squishiness of investing solely on ESG metrics. Investments and support of innovation in oil and gas may be critical to staving off commodity price shocks. Defense companies may be critical to mitigating war. Such arguments helped compel large index fund managers, such as BlackRock Inc., Vanguard Group Inc. and State Street Global Advisors, to pay greater attention to how they voted proxies on behalf of asset owners. (And BlackRock has recently launched a Washington-based ad campaign to influence government officials and legislators who question asset managers' use of ESG factors and ratings.)

Among the largest issuers, BlackRock has 22 ESG-related equity ETFs with $58.6 billion in assets, according to FactSet. The $23.2 billion iShares ESG Aware MSCI USA is the largest in the category. Vanguard offers only two equity ESG products that employ exclusionary screens, the $5.9 billion Vanguard ESG U.S. Stock ETF and the $3 billion Vanguard ESG International Stock ETF.

"Ongoing dialogue between the SEC, investors and the industry is helpful in advancing regulation that enables innovation, effective disclosure, and investor protection and education," said Matt Piro, global head of ESG product at Vanguard.

The ESG backlash coincides with three separate proposed rules by the U.S. Securities and Exchange Commission. The first, published in March, focuses on corporate disclosures of climate-related risks (and opportunities) as well as climate-related targets or goals and disclosure of direct and indirect greenhouse gas emissions (Scope 1 and Scope 2). The second, proposed in late May, updates the fund names rule and includes specific language aimed at curbing misuse of the term "ESG" in fund names. The third, proposed simultaneously with the names rule, would require funds to designate and clearly explain the level of ESG integration in the prospectus. So-called impact funds would have to disclose their "impact" metrics and environmental-focused funds would have to disclose Scope 1 and Scope 2 greenhouse gas emissions.

"It's very important to get this evolution right," Dechert's Mr. Bourgeois said. "The rules could be complex and costly to implement."