What’s in that low-carbon ETF?

Mark Hulbert writes that investors need to dig below the surface to find out which companies and investment products genuinely promote more sustainable climate policies.

CHAPEL HILL, N.C. (Callaway Climate Insights) — “Buyer beware” is good advice for anyone, but especially for those of us who want our dollars invested in ways that promote more sustainable climate policies.

That’s because our eagerness to promote such policies has made us vulnerable to greenwashing. Unscrupulous marketers have exploited our desire to believe that their clients really are promoting environmentally sustainable policies.

One relevant factoid in this regard is the number of S&P 500 companies that refer to ESG factors (environmental, social and governance) in their quarterly earnings call. In the first quarter of 2018, according to FactSet, that number was just five, compared with 71 in the fourth quarter of 2019. I think it’s safe to say that not all of that increase represents fundamental changes in how companies are treating the environment.

Clearly, we need to dig below the surface to find out which companies and investment products genuinely do what they appear to do.

Two recent cases in point are the iShares MSCI ACWI Low Carbon ETF (CRBN) and the SPDR MSCI ACWI Low Carbon ETF (LOWC), both of which are benchmarked to the MSCI ACWI Low Carbon Target Index. Together, these two ETFs have more than a half a billion dollars in assets under management.

Many of you will be surprised to learn that both of these ETFs own a number of fossil fuel companies, such as Chevron and Phillips 66 (the 7th and 10th largest oil companies in the world when ranked by revenue) and oil & gas service firms such as Halliburton and Schlumberger.

For the record, let me hasten to add that this out is not a criticism of these ETFs. Both are benchmarked to a “Low Carbon” index, not a “No Carbon” index. Nevertheless, you might still ask how low-carbon ETFs came to invest in companies for which fossil fuels are not just tangential to their business models but at their very core.

The answer is that these ETFs are not constructed with the exclusive goal of reducing their carbon footprint. They also have the goal of minimizing their tracking error relative to the overall equity market. That means that they are designed to never outperform or underperform the stock market by more than a small amount. And to live up to this goal, these ETFs must closely adhere to the sector and industry exposures of the overall market.

In other words, they can’t avoid investing in at least some oil and gas companies.

There can be little doubt that these ETFs have lived up to their goal of minimizing tracking error, as you can see from the accompanying chart. It plots the performance over the past five years of the iShares Low Carbon ETF along with the return of the ETF benchmarked to the broad market index (ACWI). Notice that the two series are almost indistinguishable.

Incredibly low tracking error

Performance over the past five years

Indeed, you would be justified in concluding that these ETFs are index funds with a hint of low-carbon flavoring. Is that what you want? As you contemplate that question, here are several more to consider:

Are you willing to tolerate greater tracking error?

To the extent that you are, then you have greater leeway than these ETFs do to eliminate certain companies and sectors from your portfolios and overweight those firms and industries that promote your environmental goals. The growth in the number of environmental funds that have low tracking error as one of their goals is recognition that relatively few investors are really willing to deviate very far from the market. But that doesn’t mean you have to go along.

There is no one right way of resolving the tension between the competing goals of environment sustainability and tracking error. But you should at least ask the question of where you stand. If tracking error is not a concern, then there is no need to invest in funds for which low tracking error is a primary goal.

What happened to the claims that doing good led to doing well?

Notice that concern for tracking error is really a worry about lagging the market, since no one is particularly upset about tracking error that comes from beating the market. And this worry about lagging the market represents a big shift from not that many years ago, when many believed that companies that were ranked high on various environmental, social and governmental scales (ESG) would consistently beat the market.

The rationale made sense, of course. Companies that didn’t pollute the environment and treated their workers well should beat the rest of the market because of fewer costs related to environmental cleanup, worker turnover, and so forth.

This outperformance has not always materialized, as we know now. Because the technology sector tends to be rated highly by many ESG rankings, ESG funds have tended to beat the overall market when that sector performs well (late 1990s, for example, and in recent years) — and to lag when that sector suffers (after the Internet bubble burst, for example). Just the reverse has been true for the energy sector, which is poorly rated by many ESG rankings: They tend to beat the market when this sector is performing poorly, and vice versa.

How do long-term benefits translate to the short-term?

So, investing in environmentally friendly companies carries the not-insignificant risk of lagging the market over the short term. This isn’t to say that a portfolio of such companies won’t greatly outperform the market over the very long term. But in a contest between that long-term potential benefit and short-term considerations like Internet bubbles and crashes, the short-term all too often wins out.

It’s a triumph of our ideological hope over reality if we think otherwise.

That doesn’t mean you shouldn’t invest in such companies, I hasten to add. You may be like many of my clients who find it insulting to think they will do the right thing only if they get paid for it.

Perhaps the most important takeaway is that you should be aware of these considerations, rather than simply invest in an ETF because of its name.

(About the author: Mark Hulbert is an author and financial markets columnist. He is the founder of the Hulbert Financial Digest and his Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com.)

Image: Woodcut by Francis Barlow, 1687; the end of "The Wolf in Sheep's Clothing".