Funds aiming to invest in the stocks of companies following good environmental, social and governance (ESG) practices were meant to revolutionize investing, providing the best of both worlds: profits for investors and making the world a better place.
So how did one of the great ESG funds of recent times, BlackRock's (BLK, Financial) BlackRock Impact U.S. Equity Fund, turn into a “sustainable” fund with oil and gas giant Exxon Mobil (XOM, Financial) as one of its holdings? Why are dozens of other impact and ESG funds rebranding as “sustainable” while abandoning their core principles? The answer lies with the unsustainable nature of an investing strategy based on buzzwords.
Buzzwords have the power to attract strong cash flow from investors, and some asset managers take full advantage of this. However, such funds typically do not work out in the long run as buzzwords lose their sparkle, causing the fund managers to scramble for alternative ways to bring in profits for investors – even if they must deviate from the fund’s original goals.
To see why and how ESG investing fails for many funds, let’s take a look at how the BlackRock Impact U.S. Equity Fund became the BlackRock Sustainable Advantage Fund.
An impactful start
The BlackRock Impact U.S. Equity Fund was launched in 2015, and at the time, the company promoted it as a way to invest in companies with “positive aggregate societal impact outcomes.” The head of BlackRock’s impact investing division called client demand “unprecedented.” It focused on ESG factors, impact factors and excluding controversial sectors such as weapons, fossil fuels and tobacco.
When client interest was not as much as BlackRock had hoped, the fund rebranded to a fresh buzzword, becoming the BlackRock Advantage ESG U.S. Equity Fund in 2019. BlackRock’s CEO Larry Fink declared shortly thereafter that climate change would bring about a “fundamental reshaping of finance.” This new ESG-focused strategy would screen out controversial companies (to a certain extent), then the portfolio mangers would pick stocks while taking ESG factors into consideration.
Sustainable is the new unsustainable
Last December, amidst increased regulatory scrutiny over the practice of greenwashing, BlackRock’s ESG fund became the BlackRock Sustainable Advantage Large Cap Core Fund.
At first, the main reason for this change appeared to be the worry that regulators might take action against so-called ESG funds they deemed were not sufficiently focused on ESG. However, at the end of this June, the freshly renamed fund owned shares of Exxon Mobil and Halliburton Co. (HAL, Financial), which are not environmentally friendly by any stretch of the imagination.
It is possible that the rebranding was due not just to regulatory pressures, but also due to the company caving to pressure to secure higher returns for shareholders. With “sustainable” in the name, it might still be able to attract some of the environmentally conscious investors without having to miss out on the returns from the rally in oil and gas stocks.
In other words, BlackRock’s sustainable strategy turned out to be unsustainable, so it looked for an easy way out. The fund’s new strategy is to profit from “climate opportunities,” which could include any number of oil and gas stocks or companies benefitting from worsening climate change.
Can some ESG funds succeed?
BlackRock is not the only asset manager whose ESG efforts have fallen off a cliff in light of increased regulatory scrutiny or lackluster returns for clean energy stocks as opposed to eye-watering gains for oil and gas stocks.
So does that mean it is impossible for ESG funds to succeed? Are they all destined to falter, either through unattractive returns or losing sight of their original goals?
Not necessarily. There is a lot of variation in funds that are focused on ESG, sustainability or adjacent themes. If you were to pick two at random, chances are they would have very different holdings. Thus, trying to lump them all into the same group is like comparing apples to oranges.
The lack of clarity on what qualifies as an ESG stock is the main reason why the Securities and Exchanges Commission is aiming to bring greater transparency and accountability to this part of the market.
From my observations, it seems that funds using buzzwords such as ESG and sustainable are much more likely to post lackluster returns and deviate from their original goals, as they are investing based on buzzwords rather than fundamentals and long-term potential.
In comparison, funds centered on specific industries, such as clean energy or electric vehicles, tend to remain laser-focused, and they are thus able to identify industry leaders to provide superior returns.
Takeaway
The deviation of many ESG-focused funds from their original goals is a prime example of why investing based on buzzwords is doomed to fail.
It is also a great example of why it is important for investors to either do their own due diligence or, as Warren Buffett (Trades, Portfolio) recommends for those who do not want to research stocks, just sit on an S&P 500 Index fund forever, since the S&P 500 has beaten most actively-managed funds in the long run.
Unfortunately, there are no shortcuts when it comes to investing. Buzzwords may hold the market’s interest for a time, but focusing on short-term market sentiment is dangerous and should never be mistaken for a long-term strategy.
