Beyond the bottom line: Four ways to think about ESG products

March 16, 2022

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People invest their money primarily to earn a profitable financial return. But today, a growing number of investors are seeking to invest in companies that reflect their values, especially with respect to social and sustainability issues.

Fund providers have met—and in many ways fueled—the demand for sustainable investments by launching a flurry of products that include ESG considerations in their investment processes. Although many of these funds wear the "ESG" label, they can vary widely in their objectives, strategies, and levels of complexity. The proliferation of ESG products and approaches, along with a lack of standardized terminology to describe them, has been a source of confusion for investors.

Vanguard offers a range of funds that can help meet the broad needs and preferences of ESG investors. But as an investor-owned company,1 our mission isn't to sell investments; it's to take a stand for investors and give them the best chance for investment success. One way we do that is by helping investors understand what they are—and what they are not—getting when they invest in an ESG fund.

Understanding ESG product approaches

Whether they're managed actively or passively, ESG funds generally fall into one of two categories based on their approach: exclusionary or inclusionary. Exclusionary ESG funds use screens to exclude sectors, countries, or companies that do not align with certain ESG criteria. Inclusionary ESG funds aim to include companies that meet certain ESG standards based on ESG ratings, data, and/or the asset manager's proprietary assessment.

As the ESG market is still evolving, there is no universally accepted taxonomy for ESG funds. Even so, the four categories described here are a useful starting point for understanding the types of ESG funds that are available today.

Four categories of ESG products²

  1. Exclusionary. These funds aim to track an index that excludes sectors or industries based on their business involvement or activities. Examples can include oil companies, weapons manufacturers, chemical companies, alcohol producers, tobacco companies, and companies that do not meet minimum human rights standards.
  2. Inclusionary. These funds can be managed passively or actively. Passive inclusionary funds aim to track an index that includes companies based on ESG ratings, the criteria of the index provider, and/or the proprietary assessment of the asset manager. Actively managed inclusionary funds explicitly look at ESG factors to identify the potential for maximizing long-term financial value. They may employ some level of top-down sector screen, but they predominantly use bottom-up evaluation techniques that focus on a company's business fundamentals. As with all active funds, these come with active risk. Since inclusionary funds vary widely in how they assess ESG criteria and in the ESG outcomes they aim to achieve, investors should take time to evaluate the security selection process of active products and the index construction process of passive products.
  3. Impact. This type of inclusionary fund has an explicit dual mandate: to produce a measurable positive financial return and a measurable positive environmental or social impact. The manager documents both the returns of the portfolio and any positive ESG impact achieved. These funds are typically actively managed, so they come with active risk. What's more, their dual mandate can require additional due diligence to determine whether they are delivering the positive impact their investors seek.
  4. Thematic. This type of inclusionary fund can be managed passively or actively. Passive thematic funds are designed to track an index made up of companies whose businesses support specific ESG themes. Examples include clean tech, green real estate, sustainable forestry, organic agriculture, education, and health care. Index thematic funds are typically less diversified than non-thematic ESG index funds and can be highly complex in how they are managed and maintained. Active thematic funds aim to beat market returns by investing in companies within a given theme, such as climate change, social justice issues, or equitable pay policies. Active thematic funds come with active risk and require due diligence to understand the security selection process.

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A final thought

When employed thoughtfully and with an appreciation for their many nuances, ESG products can offer investors a way to reach their financial goals while staying true to their values. Certain types of ESG funds may even be able to achieve a quantifiable positive impact in a particular area of social or environmental concern.

That said, ESG investing is not a one-size-fits-all solution. When selecting an ESG fund, investors should understand how it fits into their broader financial plan, appreciate the potential advantages and limitations of the strategy the fund employs, and have realistic expectations about any ESG outcomes they hope to achieve.

1 Vanguard is investor owned, meaning the fund shareholders own the funds, which in turn own Vanguard.

2 This information is intended for educational purposes for investors. These are examples of general strategy and criteria that can be used for ESG investing. The advisors of Vanguard ESG funds may not apply this same strategy or criteria. Vanguard does not currently employ all of these methods. Please refer to a fund's disclosure documents for additional details on the specific fund strategies.

Notes:

  • Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing. All investing is subject to risk, including the possible loss of the money you invest. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Diversification does not ensure a profit or protect against a loss.
  • ESG funds are subject to ESG investment risk, which is the chance that the stocks or bonds screened by the index provider for ESG criteria generally will underperform the market as a whole or, in the aggregate, will trail returns of other funds screened for ESG criteria. The index provider's assessment of a company, based on the company's level of involvement in a particular industry or the index provider's own ESG criteria, may differ from that of other funds or of the advisor's or an investor's assessment of such company. As a result, the companies deemed eligible by the index provider may not reflect the beliefs and values of any particular investor and may not exhibit positive or favorable ESG characteristics. The evaluation of companies for ESG screening or integration is dependent on the timely and accurate reporting of ESG data by the companies. Successful application of the screens will depend on the index provider's proper identification and analysis of ESG data.