Sustainable Fund? Index Fund? More Investors Choose Both

Two of the hottest trends in investing are working in tandem to steer billions of dollars toward companies seen as the best corporate citizens.

The first trend, sustainable investing, is nothing new. Funds focused on companies seen as doing well on environmental, social and governance issues have been attracting ever increasing dollars for years. Their pitch is that companies with better records on the environment are less likely to face big fines or possible bankruptcies, for example, making them less risky long-term investments.

The second trend, index investing, has become the default way for many conventional investors to get into the stock market. Now these funds are playing a much larger role in “ESG,” or sustainable, investing and turbocharging its growth.

Last year, investors shoveled a record $5.5 billion into sustainable funds. This year they’d reached $8.9 billion by the end of June, according to Morningstar.

“There are a lot of investors who would like to invest in ESG and a sustainable portfolio but haven’t done so yet partly because there weren’t low-cost, passive options available,” said Jon Hale, Morningstar’s director of sustainability research. “Now there are.”

The recently launched iShares ESG MSCI USA Leaders exchange-traded fund is one example. It’s already amassed $1.43 billion, which makes it bigger than the 81-year-old George Putnam Balanced fund that’s rated five stars by Morningstar. The bulk of that came from a single investor, a European pension fund that made a similarly large investment in the launch of another sustainable index ETF, Xtrackers MSCI USA ESG Leaders Equity, in March.

Size matters in investing, and big funds can spread their costs out over a wider base to keep fees low. Both the iShares and the Xtrackers funds have expense ratios of 0.10%, for example. That means they keep $1 of every $1,000 invested annually to cover their fees. The average stock mutual fund, meanwhile, kept $12.60 of every $1,000 invested last year, according to the Investment Company Institute.

Of the 15 sustainable funds that attracted more than $100 million in investment last quarter, eight were index funds, according to Morningstar.

It’s just the latest evolution in the sustainable investing field, which in its early days attracted investors by avoiding so-called “sin stocks”— gun makers, cigarette manufacturers, etc. More recently fund managers have begun diving deep into companies’ records on the environment, social issues and corporate governance, on the belief that it would lead to better long-term performance.

Now, sustainability minded scorekeepers keep tallies for individual companies when it comes to their corporate citizenship. ETFs that track these indexes will often give more weight to companies that have high performance on environmental, social and governance issues than those in the same industry that don’t.

Just don’t expect sustainable index funds to look radically different from traditional index funds, Hale said.

“There are things that are excluded, but you should definitely not expect to see a focused portfolio of 50 or 100 companies that are complete exemplars of sustainability,” he said. “The typical investor going through the list of hundreds of companies in a portfolio may indeed find some that make them think, ‘I don’t get it, I thought I was avoiding this company.'”

The iShares ESG MSCI USA Leaders ETF doesn’t own Exxon Mobil, for example, but it does own ConocoPhillips and other oil and gas companies.

For all the recent popularity of sustainable index funds, their actively managed rivals are still drawing dollars themselves. That’s counter to the trend in the broader industry, where investors have been pulling their cash out of conventional funds run by stock pickers in favor of index funds.

“I think active management in the ESG space can bring some elements to the portfolio that investors are really interested in, and they’re willing to pay a little premium for that work and the potential for better impact and superior performance,” said John Streur, chief executive of Calvert Research and Management, one of the largest families of responsibly invested mutual funds.