How to find a mutual fund that's truly climate friendly
How to find a mutual fund that's truly climate friendly
The greenest portfolios don't just grow on trees.
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(Mark Hulbert, an author and longtime investment columnist, is the founder of the Hulbert Financial Digest; his Hulbert Ratings audits investment newsletter returns.)
CHAPEL HILL, N.C. (Callaway Climate Insights) — Should a mutual fund manager be labeled “climate friendly” for investing in Tesla TSLA 0.00%↑ ?
The answer turns out to be surprisingly complicated. On the one hand, since Tesla is doing so much to reduce fossil fuel use, you could easily argue that a manager deserves climate-friendly credit for investing in the company’s stock. On the other hand, S&P 500 index funds also invest in Tesla, and it doesn’t seem right to call a passive index fund “climate friendly” just because Tesla is in that index.
A new study proposes an answer that is conceptually simple but quite difficult to actually calculate: Measure the extent to which a portfolio deviates from what it would have held independent of ESG.
The study’s authors refer to this deviation as the fund’s “green tilt.” This new study, titled (not surprisingly) “Green Tilts,” was conducted by three finance professors: Ľuboš Pástor of the University of Chicago, and Robert Stambaugh and Lucian Taylor of Wharton.
To illustrate the professors’ approach, imagine a fund manager who favors large-cap growth stocks but who cares nothing about the environment. (Large-cap growth stocks are those with the largest market caps that also trade at a premium because they’re expected to grow especially rapidly.) Since Tesla is a paradigmatic large-cap growth stock, this manager would be expected to own a good chunk of it. In fact, it’s the fifth largest holding in the S&P 500 Growth Index, with an index weight of 3.5%.
Glossing over many other aspects of the professors’ methodology, a large-cap growth manager would be credited with having a green tilt only if he allocates more than 3.5% of his portfolio to Tesla.
Tesla is just one stock, of course. Painstakingly, the professors repeated this calculation for approximately 2,000 publicly traded U.S. stocks and all large institutional investors in the U.S. between 2012 and 2021 (those that had over $100 million invested in U.S. stocks). Their headline finding — what is getting picked up in the financial press — is that “there is much less ESG investing than commonly reported.” Specifically, they found that “total dollar ESG-related tilt is about 6% of the industry’s AUM in equity investments in 2021.”
Which funds are most likely to be the greenest?
Receiving less attention are some of the study’s more provocative findings. One, which stands to reason as soon as you think about it, is that the mutual funds most likely to have the greatest green tilts are those that are least like an index fund. To find such funds you should focus on something that prior research called “active share” — the percentage of its holdings that deviates from its benchmark. Since a fund’s green tilt is a subset of its active share, a fund with a smaller active share will necessarily have a smaller green tilt. (Data on funds’ active shares is freely available at ActiveShares.info.)
To illustrate with an extreme example, contrast the Vanguard Index 500 Fund (VFINX0, which is the oldest and best-known index fund, with the Parnassus Core Equity Fund (PRBLX), an actively-managed socially responsible fund that made U.S. News & World Report’s list earlier this year of the “7 Best Socially Responsible Funds.”
According to the ActiveShare website, the index fund’s active share is close to zero, as you would expect. The Parnassus fund’s active share, in contrast, is 74%. If your goal as a climate-friendly investor is to go beyond what the market itself is doing already, then you would want to consider only those funds like the Parnassus Core Equity Fund with large active shares.
Another of the professors’ interesting findings is that fund managers with fewer assets under management are more likely to have sizable green tilts. The professors speculate that this is because, when deviating from an index, transaction costs are proportionally greater for larger than smaller managers. So it’s cheaper for a smaller manager to tilt green.
Yet another of the professors’ findings worth noting is that many of the companies that rate highly on one of the three ESG dimensions — Environmental, Social, and Governance — often have low ratings on one or both of the others. The implication is that investors interested in companies that mitigate global warming might want to go beyond focusing on funds’ composite ESG ratings. That’s because there’s a good chance that a fund that invests in companies with high “E” ratings will nevertheless appear to be mediocre according to its composite ESG rating.
The bottom line: To find mutual funds that go the furthest in pushing a climate-friendly agenda, confine your search to smaller funds with the highest active share. And focus on such funds’ ratings along the “E” dimension alone rather than their overall ESG score.
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