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How to Separate Real ESG Funds From the Not-So-Real

This is now a question for the U.S. Securities and Exchange Commission, as the regulatory watchdog wanders into a thicket of inconsistent standards.

(Bloomberg) -- Worldwide, there are more than 600 exchange-traded funds that claim to follow the principles of environmental, social and governance investing—in one way or another. But how many of them really do?

This is now a question for the U.S. Securities and Exchange Commission, as the formidable securities watchdog wanders into a thicket of inconsistent standards and yardsticks. In a recent examination, the regulator found both gaps in compliance and a lack of policies among such ETFs to ensure the funds actually match their publicized strategy.

And while the SEC didn’t single out any specific firms or funds for shellacking, that day is on the way. The agency warned in April of possible regulatory penalties for greenwashers.

Since then, analysts at research groups including Bloomberg Intelligence have been developing tools to help investors avoid ETFs that are inflating their ESG bona fides. “It’s a really big challenge due to the varying definitions of ESG and drastically different strategies,” said BI analyst Shaheen Contractor.

The best way to uncover questionable funds, given such an uneven landscape, is to examine their holdings and management fees, Contractor said. In general, actively managed ESG-focused ETFs are “far more opaque” and exposed to “greenwashing risks” than passively managed funds that simply track established ESG indexes, she said.

The world’s largest ESG-labeled ETF, for example, is only in the middle of the pack in BI’s ETF Exposure Scorecard.

The $17.5 billion iShares ESG Aware MSCI USA (ESGU), managed by BlackRock Inc., is an expensive fund based on its ESG characteristics, Contractor said. iShares charges a fee of 15 basis points ($1.50 for every $1,000 invested), which is high for a fund that so closely resembles its non-ESG benchmark, the MSCI USA Index.

Moreover, like many competing ESG offerings, ESGU is loaded with tech stocks, which doesn’t help differentiate it from rivals. The ETF’s largest holdings are Apple, Microsoft, Amazon, Facebook and Alphabet, which together account for almost 20% of the fund’s investments.

Three of these companies are among the biggest companies fighting the SEC over its adoption of—wait for it—new ESG-related disclosures.

Last week, Amazon, Facebook and Alphabet pushed back against SEC calls for more stringent ESG reporting in regulatory documents, such as 10-Ks, saying they’re concerned any missteps could spark shareholder litigation. “Given that climate disclosures rely on estimates and assumptions that involve inherent uncertainty, it’s important not to subject companies to undue liability,” the tech companies wrote in a joint letter to the SEC.

For an ESG-focused ETF to be heavily invested in the very companies seeking to limit ESG transparency might send the wrong signal in a market where investors smell greenwashing on every corner of Wall Street.

But some funds are measuring up. Another iShares fund (SUSL) and one from Xtrackers (USSG), both versions of the ESG MSCI USA Leaders ETF, are top-ranked U.S.-based funds on the exposure scorecard. These funds have above-average ESG characteristics, meaning the companies they invest in have higher ESG scores from both a performance and disclosure standpoint, Contractor said.

In Europe, the iShares MSCI Europe SRI UCITS ETF (IUSK), overseen by BlackRock, is a market leader for the same reasons as USSG and SUSL, she said.

“With so many ETFs battling for investor dollars, the funds that are going to survive are those with unique strategies and relatively low costs,” Contractor said.

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