We look at the ESG impact of the top three ESG funds by 2023 US inflow, and question whether they live up to their 'green' credentials.
The global financial market faced a lot of turbulence in 2022, and ESG funds were especially affected, as investors tried to avoid the perceived risk from ESG products to safeguard their wider investments. However, by the end of 2023, ESG funds had started to recover. Three ESG funds stood out, receiving the top net inflows of 2023:
Fund | Net 2023 Inflow |
iShares Climate Conscious & Transition MSCI USA ETF | $1,556M |
Xtrackers MSCI USA Climate Action Equity ETF | $1,484M
|
iShares MSCI USA ESG Select ETF | $1,257M
|
The funds track indexes that supposedly lean into holdings that are well-positioned for the transition to a low-carbon economy or that are actively engaging in the climate transition.
A closer examination of these funds shows, however, a complicated story that institutional investors often have to navigate. We compare the actual impact of these top ESG funds, with Morningstar USA Market Extended Benchmark as a reference point, to see whether they live up to their climate credentials.
Dissecting the ESG Impact
Renewable Energy and Climate Solutions
An assessment of the funds' investments in renewable energy and climate impact solutions show a disappointing result.
Compared to the broad market benchmark, iShares Climate and Xtrackers funds only had 0.7% and 0.4% more of their energy coming from renewable sources, whereas iShares ESG Select actually had 0.7% less renewable energy vs the broad market benchmark. Are we really seeing the sustainable energy transition needed to support positive climate action?
In terms of revenues from climate impact solutions—such as alternate vehicles, plant-based foods etc, the numbers fare slightly better at 2.8%, 2.2%, and a more promising 5.1% increase vs the benchmark respectively - indicating a cautious, albeit insufficient improvement.
Temperature Alignment and Climate Risks
Alarmingly, all three ETFs predominantly invest in issuers projected to contribute to a global temperature rise of over 2.5+ degrees Celsius, with 80% of their holdings falling into this category.
This contrasts with the urgent need to limit warming to well below 2 degrees Celsius, as per the Paris Agreement, highlighting a misalignment with global climate goals.
Moreover, over half of each ETFs' holdings’ physical operations face climate disaster risks, underscoring the vulnerability of these investments to the very phenomena they seek to mitigate.
When looking at aggregate physical risk, iShares MSCI USA ESG Select ETF has the least amount of absolute $ at risk from climate disasters - significantly less than the benchmark:
Products and services
Despite their ESG label, these funds maintain investments in sectors with notable environmental footprints, such as oil and gas companies, including Schlumberger and Halliburton Company.
All of them have investments that are involved in environmental damage through some parts of the revenue from their equity holdings, such as General Mills' Dairy revenue, which suggests materiality biases. A materiality-based approach instead of an alignment-based one results in overlooking smaller revenue sources that harm the environment in a portfolio (for example, General Mills 10% revenue from ice cream and dairy or DuPont's 16% revenue from Intermediates). Many small sources can amount to a large unintended impact. Which is why its important to often drill down deeper than the general GICS.
A Silver Lining: Carbon Emissions
Credit where credit is due, all three funds have demonstrated commendable performance in reducing carbon emissions, with emissions per $1M revenue significantly lower than the benchmark. This achievement translates into the equivalent of thousands of cars being taken off the road annually, showcasing a meaningful contribution to carbon footprint reduction.
Fund | Equivalent number of cars taken off the road for a year, given 2023 inflow (vs Benchmark) |
iShares Climate Conscious & transition MSCI USA ETF | 6,765 |
Xtrackers MSCI USA Climate Action Equity ETF | 7,420 |
iShares MSCI USA ESG Select ETF | 9,350 |
Assumes the average passenger vehicle emits c.4.6 metric tonnes of CO2 per year.
Same old constituents:
It’s no surprise that the same suspects make up the top holdings in each of the funds. This uniformity begs the question of the true environmental impact of these global giants.
Fund | Holding % from ‘Magnificent 7’ securities |
iShares Climate Conscious & Transition MSCI USA ETF | 25.8% |
Xtrackers MSCI USA Climate Action Equity ETF | 27.5%
|
iShares MSCI USA ESG Select ETF | 19.1%
|
The ‘Magnificent 7’ are defined as Apple, Microsoft, Amazon, NVIDIA, Microsoft, Meta, Tesla.
Physical Climate Risks
The magnificent 7 have significant exposure to physical climate risks – for example, Nvidia at a staggering 98.6% economic value at risk, Microsoft at 39.4% and Alphabet at 18.5%.
This vulnerability, especially to drought risks impacting data center operations, highlights the environmental challenges these tech giants face, emphasising the necessity for sustainable water management practices.
The Case of Water
In addition to the fact that tech companies rely so heavily on water to operate properly, sustainable water management can be a powerful tool against climate change, by building resilience, protecting ecosystems, and reducing carbon emissions.
The raw water use figures show the environmental impact of these corporations. These figures become even more noticeable when we convert them into the daily filling of Olympic-sized swimming pools:
Cumulatively, these top constituents use the equivalent of 95 Olympic-sized swimming pools of water every day—a figure that starkly contrasts with the climate-friendly image these ESG funds aim to project.
ETF Water Usage
When extending the analysis to include all holdings within the ETFs, the water usage figures become even more staggering. The iShares Climate Conscious & Transition MSCI USA ETF, Xtrackers MSCI USA Climate Action Equity ETF, and iShares MSCI USA ESG Select ETF account for the equivalent of 3,661, 4,369, and 335 Olympic-sized pools of water used per day, respectively.
Notably, the iShares USA ESG Select ETF demonstrates a significantly lower water footprint, using 13 times less water than its counterparts.
To put these figures into perspective, the water usage by the Xtrackers ETF holdings’ is equivalent to filling 36.5 Shards, or 12.4 One World Trade Centers—every single day.
This not only calls into question the climate tilt on these funds, but also the interplay of the high water use and the dependency on water from the top constituents of them.
The Implications for Investors
While these ETFs may perform well in certain ESG metrics such as carbon emissions, the significant water usage for example of their top constituents raises important questions about the holistic risk of the investment strategies and their long-term viability. How long will the planet have enough water to sustain the magnificent 7?
ESG is a tool – that when used correctly can mitigate a large swathe of these issues. For example, look at our recent work for a large European Pension Plan. Our portfolio engineering solution, SmartESG, resulted in an optimised portfolio having no change in tracking error and substantial environmental improvements, including up to 90% reduction in carbon emissions, freshwater usage, and waste generation vs. MSCI ESG Enhanced and MSCI Paris Aligned benchmarks.
Maybe it’s time investors moved away from broad market benchmarks and looked at creating their own custom solutions?