Most ESG funds land in one of four cohorts: exclusionary, strong ESG practices, impact, and thematic. These cohorts can be arranged from broad to focused, as Exhibit 1 illustrates.

There is a trade-off between the strength of ESG exposure that funds in each cohort provide and the active risk they bear. Broad funds offer mild ESG exposure and have well-diversified portfolios. As a result, they tend to have low active risk and tracking error relative to the broader market. By comparison, focused funds have stronger exposure to exemplary ESG firms, but it comes from narrow and sometimes concentrated portfolios that can look and perform very differently from the market. The right balance between ESG exposure and active risk is a matter of personal preference. With so many options available, there's likely a fund that aligns with your preference.

Here's a closer look at how funds in these cohorts approach ESG investing and the perils the come with each.

Exclusionary

Exclusionary ESG strategies generally offer broad exposure to the market but aim to avoid stocks with undesirable characteristics. Most start with a broad market index, like the S&P 500 or Russell 1000 Index, and remove stocks closely tied to certain lines of business. These often include companies linked to fossil fuels, alcohol and tobacco products, weapons, and gambling, among others. This focus is less about how firms are operating than the lines of business they happen to be in. Companies involved in significant controversies, like the Volkswagen emissions scandal, may also be excluded from these funds.

These portfolios tend to look similar to their parent index. The sector and stock weightings of these funds may differ slightly from the market, but they still tend to closely represent the index that serves as their starting point. Exclusionary strategies typically have well-diversified portfolios and low amounts of active risk. Tracking error relative to the market usually lands around 1 percentage point or less.

Many exclusionary strategies don't directly consider the ESG practices of their holdings. For example, Vanguard ESG U.S. Stock ETF (ESGV) doesn't consider corporate governance practices or the environmental impact of its holdings. IShares MSCI KLD 400 Social ETF (DSI) follows a similar approach.

Some broad, exclusion-based funds are designed to appeal to certain values, like Global X S&P 500 Catholic Values ETF (CATH). This strategy starts with all stocks in the S&P 500 Index and excludes those that fail to meet the United States Conference of Catholic Bishops' socially responsible investment criteria. Historically, the strategy has held 450-470 stocks, while its 10 largest holdings have typically landed between 15% and 25% of assets. CATH also keeps sector weightings in line with those of the S&P 500, so it fulfills its remit while maintaining a well-diversified portfolio.

Strong ESG Practices

Funds that emphasize strong ESG practices go beyond simple values-based exclusions. They employ positive screens to target stocks with desirable ESG traits and focus more on how a company makes products than the goods or services it produces. These portfolios may have low to moderate levels of active risk, depending on how they are built and the strength of their ESG exposure.

IShares ESG Aware MSCI USA ETF (ESGU) is among the most constrained funds in this group. It uses an optimizer to select and weight stocks based on their ESG scores, subject to constraints like sector weightings, stock weightings, and turnover that are intended to promote diversification and curb trading costs. ESGU also restricts its tracking error to 0.5% of the MSCI USA Index, which is close to that of exclusionary strategies like ESGV. Exhibit 2 shows that both funds have similar ESG exposure, as measured by their Morningstar Historical Portfolio Sustainability Score relative to their Morningstar Categories.

IShares MSCI USA ESG Select ETF (SUSA), which has a Morningstar Analyst Rating of Silver, uses a similar approach, but it has more latitude to pursue strong ESG firms. It uses an optimizer to maximize the portfolio's exposure to strong ESG firms, subject to an expected tracking error of 1.8% against the MSCI USA Index. That additional freedom allows it to tilt more toward stocks with high ESG scores than ESGU. Its historical sustainability score percent rank is lower than ESGV's and ESGU's, indicating that it has stronger ESG exposure.

Silver-rated IShares ESG MSCI USA Leaders ETF (SUSL) doesn't have any direct constraints on tracking error or active risk relative to its parent index. It selects the top ESG scoring firms from each sector until it captures 50% of that sector's market cap. Capturing half of the market with nearly identical sector weightings helps limit active risk. Its tracking error and ESG exposure land near SUSA's.

These three funds demonstrate the connection between funds' active risk and the strength of their ESG exposure. Emphasizing ESG criteria requires more tracking error and active risk, so funds with stronger ESG exposure tend to deviate further from the market. All of these strategies take measures to promote diversification and are suitable as core holdings.

Impact

Impact strategies invest in businesses making products that help solve societal and environmental problems. Few companies in the broader global market meet these criteria, so impact strategies don't provide the same diversification potential as exclusionary or strong ESG practice funds, and they can possess higher levels of stock- and sector-specific risks.

IShares MSCI Global Impact ETF (SDG) is one of the leading examples of an ESG impact fund. It looks for stocks in the MSCI All Country World Index that generate at least half of their sales from one of 11 sustainable categories, including alternative energy, sustainable water, pollution prevention, sanitation, and education. It then weights eligible stocks based on the fraction of their revenue that comes from products and services related to these categories. Stocks with a higher percentage of revenue from these categories receive larger weightings. It also applies constraints to stock and sector weightings to improve diversification.

The strict standards that impact strategies impose give them narrower portfolios than the exclusionary or integrated approaches. As of January 2021, SDG held about 130 of the nearly 3,000 constituents in the MSCI ACWI. While it employs constraints on stock and sector weightings, it still heavily favors certain segments of the market. SDG overweights stocks from the industrials, healthcare, and consumer staples sectors compared with the global market.

These deviations from the market cause ESG impact funds to bear more active risk than exclusionary and integrated strategies. SDG's tracking error ran high over the three years through January 2021, coming in at 6.8 percentage points relative to the MSCI ACWI.

Thematic ESG

Thematic ESG funds are different from the other three types because they focus on a specific ESG issue. Examples include SPDR SSGA Gender Diversity ETF (SHE), which invests in companies where women are well represented in the leadership ranks. Ecofin Global Water ESG Fund (EBLU) is another example. It focuses on global companies with the potential to profit from providing clean water.

These funds offer more potent exposure to specific ESG issues, but their acute focus means they will look and perform very differently from the market. Thematic strategies can possess more active risk than the other three types of ESG strategies because they tend to be much more concentrated in certain stocks and sectors. Therefore, they are best used as a satellite holding to complement a diversified portfolio. As of January 2021, almost all of EBLU's assets were split between stocks from the industrials and utilities sectors. It held only 37 names, while its 10 largest holdings represented about 60% of its assets.

Thematic ESG strategies assume that their chosen stocks will profit from a given theme, with many using positive screens to ensure eligible stocks earn a portion of their sales come from operating activities related to the desired ESG initiative. Even so, many publicly traded companies can have other operations that can mute their exposure to a particular cause.

The Choice Is Yours

The right ESG strategy for each investor is a matter of personal preference. But it is important to understand the trade-off between ESG exposure and active risk. Achieving higher ESG exposure will likely require more tracking error and active risk.

Funds in the exclusionary and strong ESG practices cohorts maintain high levels of diversification and modest amounts of tracking error, making them suitable as core holdings. But they have differences. Exclusionary funds use values-based screens to eliminate stocks tied to certain lines of business or products. Funds focused on strong ESG practices look more closely at the way a firm produces goods and services, emphasizing names with strong ESG alignment.

Impact and thematic ESG strategies are more concentrated and have high levels of active risk. Impact funds look for companies that are trying to solve environmental and societal problems, while thematic funds focus on a specific ESG issue. Both approaches have high amounts of active risk and are more appropriate as satellite holdings.

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