If you favor companies that are working toward a sustainable world, ESG funds offer the easiest way to invest in them. These funds encompass companies striving for positive environmental and social impact and responsible governance. Better yet, studies show that companies pursuing a healthier planet, diverse and well-treated workers, and responsible executive pay don't sacrifice their financial performance to achieve those goals. ESG funds may allow investors to do well for themselves while doing good for the world.
Higher returns, lower risks
According to the Morgan Stanley Institute for Sustainable Investing, U.S. sustainable stock funds in 2020 outperformed their traditional peer funds by a median total return of 4.3 percentage points, with 3.1 percentage points less downside risk than their traditional peers. iShares USA ESG Select ETF (SUSA -0.26%) posted an impressive 30.45% return, outperforming the median peer fund in the Morgan Stanley study by over 10%.
Sustainable funds can outperform partly because the companies they invest in are less likely to incur negative publicity or costly regulation over their working practices or harmful emissions. Correctly or not, investors increasingly believe that companies that meet their sustainability goals can generate higher profits over time than companies that don't.
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To make sure sustainability funds live up to their lofty goals, check their ESG ratings. Using financial data and company reports, data providers Morningstar and MSCI rate these funds from worst to best – either on a scale of 1 to 5, or CCC to AAA – based on how well they keep their promises. Among other things, scores consider whether funds exclude holdings from industries like tobacco, firearms, or fossil fuels, and whether they divest companies that fall short of sustainability or invest more in businesses cleaning up their acts.
The iShares USA ESG Select ETF has a Morningstar score of 5 and an MSCI score of AAA, while a competitor, the Calvert Equity Fund-A (CSIEX -0.09%) has scores of 5 and AA, respectively. The iShares fund scores higher with MSCI in part because its Top 5 holdings include only one stock with an MSCI rating below A: Alphabet Inc Class A (GOOGL 0.35%), which is rated BBB, average for its industry. The Calvert Equity Fund's top five include four with only a BBB rating: Alphabet, Thermo Fisher Scientific (TMO -1.05%), Danaher Corporation (DHR -1.27%), and Verisk Analytics (VRSK 0.49%) Unlike standardized S&P bond ratings, Morningstar and MSCI's approaches to scoring sustainability differ, so you should use both to research different funds.
Returns, risk and costs are important
In addition to the ESG score, most investors are looking for how the fund performs over time versus a broader sampling of stocks across the market.
While many sustainable funds have posted better-than-market returns, passive funds, which aim to maintain a representative and diversified sampling of stocks, may be better able to weather the ups and downs of markets at lower cost than actively managed funds with a more limited selection of holdings. The iShares USA ESG Select ETF encompasses 180 companies, which helps it balance out volatility in any one sector of the market.
Just as with mutual funds and ETFs in general, costs can vary. The expense ratio for an actively managed fund such as Calvert Equity A can approach 1% – 0.94%, in Calvert's case – while passive funds like iShares USA ESG Select ETF have expense ratios in the 0.10% to 0.25% range. Investors should weigh whether an active fund's performance and ESG scores are worth its higher cost.
You can invest in a sustainable world
While the number of sustainable funds are growing, so are the tools to evaluate them. Look for ESG investing funds that offer strong scores, high performance against the market and their peers, and lower expense ratios. If you're looking for a diversified fund that scores well in sustainability and boosts your portfolio's return, iShares USA ESG Select ETF might make a great place to start your search.