How Vanguard looks at ESG product development

November 3, 2021

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Investment products with an environmental, social, and governance (ESG) focus are not new. The first such mutual funds go back decades, and Vanguard's first ESG fund, Vanguard FTSE Social Index Fund, was launched in 2000. What is new is the rapid recent growth in the array of ESG strategies and product offerings.

In the year ended June 30, 2021, U.S. ESG assets under management grew 79%, to $313 billion, with index-based products taking in 67% of net cash flows. The number of products available surged the same year by 23%, to 454, across mutual funds and ETFs.

ESG assets in U.S. mutual funds and ETFs

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Note: Figures show the number of ESG-focused mutual funds and ETFs in the U.S. market and their aggregate assets under management as of June 30 each year since 2017.
Source: Morningstar, Inc., as of June 30, 2021.


Some investors have wondered why Vanguard's ESG product lineup hasn't grown at the same pace as the industry's. While our ESG assets under management (AUM) have grown significantly during this time, we've introduced only one new ESG product for U.S. investors, Vanguard ESG U.S. Corporate Bond ETF, since the beginning of 2020.

But the small number of new Vanguard products shouldn't be interpreted as a statement on ESG investing. Our approach to product development primarily has to do with our ownership structure and core purpose. The ESG U.S. Corporate Bond ETF launch followed a multiyear research process that predated the recent surge.

To be sure, all companies seek to do right by their owners—whether they are public shareholders or private shareholders. Vanguard is owned by our U.S. funds, which are owned by their investors. To do right by our owners, we strive to stand for all investors and give them the best chance for investment success. Therefore, one of our greatest responsibilities is the development of the products we put in the marketplace. Because of that, all product research follows a time-tested set of product design principles.

What are Vanguard's product design principles?

Our product design approach rests on four essential questions:

  • Does the proposed product have enduring investment merit? We must have conviction a product is capitalizing on an investment thesis that has the potential to thrive for decades to come.
  • Does it fulfill the long-term needs of its targeted clients? Because our investors are our owners, the product must contribute to their success as part of a well-diversified portfolio.
  • Can we deliver a compelling advantage over competitors? We assess how a Vanguard product can stand out in the marketplace. We look at factors such as in-house investment management capabilities across our indexing and active fixed income teams and our ability to secure the best external active equity managers at an advantageous price.
  • Is it feasible to launch the product? Finally, we assess all potential legal, regulatory, and operational constraints to ensure that the product is viable.

A rigorous process guides every product launch

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Product ideas are winnowed in a multitier approval process. It begins with our Portfolio Review Department, which is responsible for all aspects of product research, strategy, management, and manager search and oversight. Product proposals then go through due diligence review by our Global Investment Committee, led by Vanguard's CEO. Ultimately, all approved product proposals move to our board of directors, which makes the final decision whether to proceed with a launch.

How ESG figures into product design

An ESG focus brings additional considerations into the product design process, focusing on how best to measure a strategy's progress toward its objectives. Some ESG strategies place high priority on avoiding certain sectors or businesses while others actively seek to drive specified social outcomes or sustainability. ESG strategies may also hinge on whether companies are governed by a diverse board and demonstrate strong stewardship.

"When considering new ESG products, we assess factors such as variations in index providers' methodologies or active managers' approaches, and general investor motivations and expectations," says Sarah Hersh, senior ESG product manager in the Portfolio Review Department. "We also ask whether the product would be broadly diversified and how it may perform on investment and ESG outcomes, relative to an unconstrained parent index."

As of today, Vanguard's ESG lineup for U.S. investors consists of five products:

  • Four are exclusionary index products, three equity and one fixed income, which are broadly diversified and seek to track benchmark indexes that are reasonably constructed and have transparent definitions of the sectors or business practices they seek to exclude.
  • The fifth, Vanguard Global ESG Select Stock Fund, is an active inclusionary product managed by Wellington Management Company LLP. The advisor seeks to identify companies that, among other characteristics, demonstrate ESG leadership and the potential for higher-than-average returns on equity.

"Our exclusionary products give investors a range of options for avoiding exposure to certain ESG risks or expressing their values," Ms. Hersh says. "Our active product enables investors to access companies with a strong return on capital and leading stewardship practices, a combination the advisor expects to deliver alpha over the long term."

What's next?

The U.S. mutual fund and ETF industry is evolving to include a wider range of approaches. For example, impact investing is an active approach that explicitly seeks to generate positive total return and a real measurable social or environmental outcome. Thematic investing can use active or passive strategies to target companies with mandates such as encouraging energy transformation or addressing climate change. Inclusionary index products are often based on an ESG ratings provider's assessment of company management of ESG issues.

"ESG strategies are a significant focus area in our current research efforts," says Ms. Hersh. "We have confidence in the merit of ESG investing broadly, and the thoroughness of our research process reflects our commitment to deliver enduring, compelling products to our clients."

While ESG investing is continually evolving, Vanguard's commitment to our product design principles remains constant. We believe those principles will help ensure that any product we offer will benefit our investors—our owners.

For more information, see our roster of ESG investments. You can also contact your Vanguard representative.

Notes

For more information about Vanguard funds or Vanguard ETFs, visit institutional.vanguard.com or call 800-523-1036 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

All investing is subject to risk, including the possible loss of the money you invest.

Diversification does not ensure a profit or protect against a loss.

Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments. Investments in bonds are subject to interest rate, credit, and inflation risk.

Investments in securities issued by non-U.S. companies and governments are subject to risks including country/regional risk and currency risk.

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.