Why the green fund you bought might include a coal miner

NEW YORK (AP) — Environmentally conscious investing received a lot of attention last week after the world’s largest asset manager said it plans to put climate change and sustainability at the center of its investment approach.

The decision by BlackRock Inc. should create more investment opportunities for those interested in funds that take environmental, social and governance issues into account — known as ESG funds — before they buy a stock or bond. Billions of dollars are already flowing into such funds — $20.6 billion last year, up from nearly $5.5 billion in 2018.

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Green investing isn’t as simple as it sounds, however. Just because BlackRock or any other fund manager slaps an ESG or sustainable label on a fund doesn’t necessarily mean it completely syncs with an investor’s priorities.

“I don't think these things have been very well defined so far,” said Chester Spatt, finance professor at Carnegie Mellon's Tepper School of Business and former chief economist at the Securities and Exchange Commission. “ESG investing is emerging and increasingly important, and I think this will be a first-order issue on regulators' agenda in the next few years."

Here's what investors should know about this type of investing:

— WHAT DO ALL THESE ACRONYMS LIKE ESG AND SRI MEAN?

These two get used interchangeably sometimes, but “environmental, social and governance” investing can be quite different from “socially responsible investing.”

ESG is the more popular acronym now, and it implies managers consider companies' performance on the environment, social issues and corporate governance before investing in them. The thought is to avoid companies with poor track records on ESG issues that could be exposed to big potential fines or other blow-ups in the future. ESG is as much a tool to reduce risk in investments as anything.

SRI, meanwhile, is more akin to investing alongside one's morals. The term has fallen out of favor with some, though, who worry it's too reminiscent of the industry's earliest funds decades ago that simply excluded tobacco companies and other “sin” stocks rather than doing more rigorous analysis.

— WILL ANY ESG FUND DO?

Not by a long shot. Prepare to do your homework.

To see how nuanced things can get, consider BlackRock’s blockbuster announcement. As part of its effort to put climate change at the center of its investment strategy, BlackRock will exit investments in stocks and bonds of certain coal producers.

BlackRock is dumping companies that get more than a quarter of their revenue from thermal coal, which is primarily used in power generation and creates lots of carbon emissions. These investments are risky because of the possibility of profit-reducing regulation and because power plants are increasingly switching to natural gas and other fuels. But BlackRock will still invest in companies that mostly sell coal used in steel plants.

Furthermore, BlackRock is only eliminating thermal coal producers from the portfolios where its managers are actively choosing which stocks and bonds to own. BlackRock's index funds, which account for the bulk of its $7 trillion in assets under management, will continue to own coal producers as long as those companies remain in the indexes they track. The most popular index funds tend to track the broad stock market, which means they typically include coal miners, oil explorers and other fossil-fuel companies based on their market value.

For its part, BlackRock promises to work with index providers to come up with more and better sustainable indexes, which can lead to new index ETFs. But just like an investor can't blindly jump into a “growth” or “value” stock fund and assume they know what the manager's philosophy will be, investors need more details before they consider joining the sustainable investing field.

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— DO I HAVE TO ACCEPT LOWER RETURNS?

Some investors, even some big pension funds, assume that limiting the universe of potential investments and having less diversification inevitably leads to either worse returns or more volatility.

But several studies have pushed against this. After looking at the performance of more than 10,000 mutual funds and ETFs from 2004 to 2018, Morgan Stanley found there is no consistent or statistically significant difference in returns between ESG-focused and traditional funds. The study also said that sustainable funds may have less violent swings during down markets.

— WHAT IF I DON'T WANT TO OWN ANY OIL COMPANIES?

Do your homework before buying. Some funds swear off fossil-fuel companies entirely. But others don't want to completely eliminate them. Instead, they’ll favor companies that are relative leaders in the industry when it comes to environmental, social and governance issues and own less of the laggards.

So, anyone buying a share of BlackRock's iShares ESG MSCI USA exchange-traded fund shouldn't be surprised to learn Exxon Mobil is its 20th largest holding. BlackRock discloses that on its website, and it also details the index's approach in its prospectus.

— WHAT DOES IT MEAN TO HAVE A HIGH ESG SCORE?

Just like companies have credit ratings, they also have ESG scores, assigned by companies like MSCI, Sustainalytics and others. Fund managers often use these scores to help decide whether to include a stock in their fund.

But one company can have very different ESG scores from different ratings companies, even though they look at the same sets of data, said Jennifer Coombs, associate professor at the College for Financial Planning.

“That's an area that's causing angst,” she said. “What’s an investor supposed to do if the same information is going to move two firms’ scores in the same direction only a third of the time?”

Coombs said she’s hopeful such discrepancies can improve over time as regulators require companies to make more disclosures about environmental and other issues.

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— WHAT ABOUT HIGHER FEES?

Sustainable funds were notorious years ago for being more expensive to own, certainly compared with broad index funds. But fees have been coming down as more dollars flow into the field, which allows for expenses to be spread across larger pools of dollars. More index funds have also come into the space, which reduces costs.

In BlackRock's iShares family of ETFs, for example, its largest sustainable fund has an expense ratio of 0.15%. That means $15 of every $10,000 invested goes to covering fees annually. That compares with $4 for iShares' largest ETF, which tracks the broad S&P 500 index. The average stock fund kept $55 in 2018, according to the Investment Company Institute.