Why Most Eco-Friendly Investment Funds Really Aren’t That Eco-Friendly

It’s Earth Day. You care about the planet. You don’t want the polar ice caps to melt, and you don’t want paradise to be turned into a parking lot, like in that kind of preachy yet brilliant Joni Mitchell song.

Listen, we get it. And so does Wall Street, apparently.

This might come as a shock (it won’t) but historically, funds and asset managers haven’t particularly cared about the environmental policies of the companies they invest in, so long as they made money. This is changing — there’s a strong argument that it may be too late, but still. The financial industry has begun building products for people who want to do good — or at least not cause harm (which — spoiler — is much more what a lot of these products are about) with the money they’re investing. These products are often called Socially Responsible Investing, or SRI.

Tons of small individual investors are now pumping money into SRI exchange-traded funds (ETFs) and the like. The issue is, because of how funds select their investments, a lot of these funds are filled with stocks in companies that aren’t responsible. Like, at all. And unless you have heaps of time to research and pore through prospectuses (you don’t), it’s super freaking hard to know if any given SRI fund actually does what it claims to.

To help you figure out which SRI funds are good for, and how to know if they live up to their name, we drew up this handy guide to understanding just how responsible your SRI is.

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What exactly is SRI?

First, the basics: socially responsible investing is a strategy in which investors avoid profiting off companies that wreak havoc on society and the planet.

Easy enough, right? The trouble is that how portfolio managers decide which companies wreak havoc is, well, super subjective. Funds tend to focus on environmental issues, but many are also designed, at least ostensibly, to also focus on sustainable growth, diverse workforces, and equitable hiring practices. Oil companies, weapons manufacturers, major carbon emitters — many SRI mutual funds and ETFs, like the two Wealthsimple launched in 2020, aim to exclude these objectionable companies from their asset mix. (Some don’t, though; more on this later.)

Over the past several years, institutional investors — the BlackRocks and Vanguards of the world, but also large pension funds and obscure hedge funds — have gotten into the SRI game. “People fight about the existence of climate change in political circles,” explains Ben Reeves, Wealthsimple’s Chief Investment Officer, “but it’s not really a question in the markets; they know it’s real.” As a result, Reeves says, “companies are seeing real investor pressure to improve sustainability, and some projects, like coal mining projects, are having trouble getting insured due to pressure on insurance companies.”

Many funds that purport to be socially responsible hold oil and gas stocks.

Wait – so why exactly do these funds exist?

To spur better behaviour and manage climate risk, of course. Another reason they exist is that financial companies can charge higher fees for the service of building and maintaining them. The service they provide investors isn’t only activist, though; it can also be about risk and return. The U.S. Atlantic Coast, for instance, currently sees about three major hurricanes a season — storms that routinely cause billions of dollars in damage. As the oceans continue to warm, the number of hurricanes making landfall promises to increase, perhaps to as many as nine a season, according to one projection. That’s not terrific news for anyone, really, but especially not for oil companies with offshore platforms and coastal refineries, which aren’t exactly cheap to replace if they get mangled or shuttered. Many SRI funds value companies based on such climate-related exposures and favour those that will likely prove resilient and profitable as climate change worsens.

The risk and return track record of socially responsible investing is mixed. Some argue that by finding factors that are relevant to company performance, like catastrophic climate risk to insurance companies, you can outperform the market. Others argue that because the market does a pretty good job of pricing in risks, the money and interest flowing into responsible funds means that less responsible companies have to offer higher returns to get capital. The realized track record is mixed. Because there are a lot of approaches to SRI, some funds outperform, and others underperform, without a clear pattern.

How does anyone know how socially responsible an SRI fund really is?

As socially responsible investing has come into vogue, indices and rating agencies, like Standard & Poor’s, have begun giving companies what are known as environmental, social, and governance (ESG) scores. These third-party ESG scores offer a snapshot of a company’s eco-friendliness and corporate culture, based on emissions, government compliance, climate-related exposure, and pay equity, along with other criteria along similar lines.

A lot of financial companies don’t do any research on companies themselves; they just rely on these ESG scores when selecting which stocks to include in their SRI funds. If these ESG scores are flawed, then all those funds that rely on them will be flawed too. And the catch with ESG scores is that there’s a lack of consensus about which companies fall into the bad, do-not-invest bucket and which companies get a green, or at least greenish, seal of approval. And, worse, those scores can be manipulated. “There’s a lot of greenwashing that goes on,” explains Reeves.

If the ratings are off, how can you possibly have a responsible SRI?

SRI portfolios are only as good as the ratings they use — which is a problem since ESG scores have proved extremely unreliable. Consider this: not long ago, Tesla earned the best ESG rating among global automakers according to the index firm MSCI. Meanwhile, Tesla placed not just low but dead last among automakers in a separate analysis by the research group CLSA. So, depending on which rating you believe, Tesla is either the world’s most environmentally friendly car company or the worst.

Because of such discrepancies, says Reeves, “it’s very difficult to say what these ratings mean, if anything.”

Then there’s the added complexity of companies purposely trying to goose their own environmental image — greenwashing. In 2018, a number of companies signed a pledge to “protect the environment by embracing sustainable practices across [their] businesses.” A subsequent study, however, found that companies that signed the pledge were more likely to have environmental and labour-related compliance problems than other companies.

Further muddying things, funds and asset managers themselves partake in greenwashing. Many funds that purport to be socially responsible hold oil and gas stocks — just fewer of them than other funds, or they own shares of the least bad of the bad oil-and-gas companies. Such is the case with BlackRock’s Carbon Transition ETFs.

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What’s the solution? Do more research. Wealthsimple, for instance, ditched its original ESG-ratings-based SRI funds a few years ago, believing it wasn’t as socially responsible as it could be. We spent a year researching and screening out bad stocks to create two new SRI ETFs, which launched in 2022. “We don’t use ratings. We use objective, non-ratings criteria,” Reeves says. “We use information like which industry a company is in, its carbon emissions, and its board gender diversity.” The Wealthsimple ETFs exclude not only all fossil fuels, tobacco, and weapons companies but also the top 25 percent of carbon emitters in each industry and any company with a board that isn’t composed of at least a quarter women.

Your SRI portfolio is a powerful tool. But it’s not enough on its own.

Don’t get us wrong: SRI portfolios are good for a few things. First, they keep investors from investing in things they don’t want to support. Second, they create demand for a system where companies are monitored and audited to make sure they’re not being evil. When you measure things, it tends to change behaviour. And they’re also a signal that both large institutional investors and small investors (especially Millennials, according to data) care about climate and social issues. This fact alone might dissuade corporations’ from continuing polluting and carbon-emitting practices, which is, you know, a net benefit.

But it’s also important to know what SRIs can’t accomplish. They can’t, say, come in and stage a coup like Engine No. 1, a San Francisco-based activist investment firm, did in June 2021, when it installed three directors on ExxonMobil’s board, in hopes of shifting the company away from fossil fuels. ETFs can’t start a new company that pulls carbon from the air or require that a certain percentage of the power grid be backed by renewable energy. “It’s extremely difficult to fund worthy projects as a small investor or in public markets,” Reeves explains.

If your primary objective is change, there are ways to accomplish it that are more potent than investing. Voting and organizing, for example. Or even changing your consumption habits — if you don’t want to support car companies that make gas guzzlers, don’t buy their products. Public pressure is another potent tool. Walmart and Dick’s Sporting Goods both restricted gun sales because of a public outcry following the mass shooting in Parkland, Florida, in 2018. More recently, some of North America’s largest (and arguably most miserly) companies, including McDonald’s and, again, Walmart, upped their entry-level pay from about $8 an hour to a marginally better $11 to $15 an hour — and they didn’t merely act out of the goodness of their hearts; people were picketing outside their stores. (This was pre-labour shortage, when a tight job market forced many companies to up their prices to attract workers.) Companies have begun to feel a similar squeeze over emissions and pollution. Early this year, GM announced that it would sell only zero-emissions vehicles by 2035, in response to consumer demands and reinstated fuel-economy rules under President Joe Biden.

No matter how much you invest in an SRI fund, you’re still dealing with companies whose main motives are, more often than not, profit and growth. If creating change is your first priority, helping organizations whose main motive is that change is a good place to spend your capital (or time). (That’s why we launched, and support, the Wealthsimple Foundation.) Nonprofit organizations can be more effective when it comes to shifting public opinion, corporate behaviour, and governmental policy than any ETF. In the fall of 2020, for instance, the U.S. Army Corps of Engineers denied a permit to the company behind the Pebble Mine, a proposed, ecologically risky project in Alaska, after a D.C.-based environmental group released recordings of a mining executive saying, in effect, that his company had lied about the project’s length in permit filings. If work like this is important to you, funding the organizations that do the work is the best way to support it.

This story was first published in July 2021 and updated in April 2022.

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