What is an ESG index fund?

When Katie and I ran the second Rebel Finance School one of the questions we got asked the most was about ESG funds. So we’ve written this mega article covering everything you need to know about ESG index funds.

What does ESG mean

Let’s start with what ESG means; it stands for Environmental, Social, Governance. The idea is that the fund is made up of companies that are more ethical, more sustainable, better for the environment and better run than other companies.

The hope is that by investing only in the ethical companies we can make the world a better place whilst creating a profit.

Sounds like a good idea but my biggest concern is that this leads to stock picking and therefore worse performance (profit for us) over time.

My assumptions about ESG funds

Here are my assumptions about ESG index funds before writing this article:

1. They are an index fund with a bunch of companies removed that don’t fit someone’s idea of what a sustainable, environmental and well managed company is.
2. It is a form of stock picking because someone is deciding what an ESG company looks like and picking what is a good company (did I say I don’t like stock picking?)
3. The criteria are a bit obscure and I am not entirely sure what I am buying when I get one of these funds which makes me nervous to buy them. I know if I buy the FTSE Developed World fund or the FTSE global all cap index I am getting a slice of every company in the index. I don’t know what I am getting in an ESG fund and this makes me nervous.
4. These funds will perform worse over time compared to traditional index funds because of the above reasons. I know the argument is made that they will do better because you are investing in companies that will do the right thing and therefore perform better over the long term. I am just not sure I believe this. Any form of stock picking for your average investor usually leads to worse performance over time.
5. Investing my money into ethical companies won’t make a difference to us or the health of our planet. What will make a difference is if we shift our spending and buy products from ESG companies. This would then lead to the traditional indexes naturally being formed exclusively of these companies. So why would I bother? I just need to vote with my spending pounds/dollars not my investing pounds/dollars and persuade others to follow.

I am not the biggest fan of these funds currently. However I am open to changing my mind based on data and information.

YouTube video about ESG funds

We made a video for you explaining what an ESG fund is. Check it out and please give it a like, comment or subscribe to support the channel and help us reach more people.

​​A brief history of ESG or SRI funds

I started searching for the first ESG funds and found that they weren’t always called ESG funds. They used to be called Socially Responsible Investing (SRI) funds. Let’s start at the beginning.

1758: The Religious Society of Friends in Philadelphia bans it’s members from investing or participating in the slave trade. This was not illegal at this point and seems to be the first stance in ethical investing. YAY

1927: The first publicly offered socially responsible investment fund was created. It was called the fidelity mutual trust fund and later became the Pioneer fund. This is an actively managed fund.

1985: Friends Provident launched their first ethically screened investment fund which excluded tobacco, arms, alcohol and oppressive regimes. This seems to be the longest running SRI/ESG fund that I can track.

2006: The Principles for Socially Investing Organisation is launched at the NYC stock exchange by Kofi Anan of the UN.

Since then, there has been an explosion in funds that are called ESG. All with different criteria and different ideas of what ethical investing is. Some focused on climate change and others focused on driving board diversity and equality. You can choose a fund to match any type of ethical investing.

​​What is an ESG index fund?

My assumption is that it is one of the broad based index funds like the FTSE Global All Cap Index Fund but with a whole bunch of companies stripped out.

This is how Vanguard describes it. “The Fund promotes environmental and social characteristics by excluding companies from its portfolio based on the impact of their conduct or products on society and/or the environment.”

Sounds like my assumption is correct so far. They take the original index, look through and remove a bunch of companies based on certain criteria.

Who decides what companies are in an ESG index fund

How do the creators of the indexes choose which companies live up to the standards they set or not? What are the criteria for choosing?

As it turns out it isn’t Vanguard who chooses which companies to exclude from the ESG funds. All Vanguard funds (both standard funds and ESG funds) are based on underlying benchmark indexes.

There are benchmark providers that provide the benchmark indexes to Vanguard. They work out which companies to include in the standard and ESG benchmark indexes. The two benchmark providers Vanguard uses are FTSE International Limited and MSCI Inc (formerly Morgan Stanley Capital International and MSCI Barra) .

The standard fund is based on the MSCI benchmark and the ESG fund is based on the FTSE benchmark. The funds aim to track these benchmarks are closely as possible.

FTSE benchmark

Let’s stick with FTSE for now. So FTSE are the ones that tell Vanguard which companies to include in their funds. And they are the ones that have excluded some companies from the ESG benchmark funds. FTSE exclude companies based on the products/services they provide and the conduct of the company.

Companies that provide the following products/services are removed from the index:

• Non-renewable energy (nuclear power, coal, oil and gas)
• Vice products (adult entertainment, alcohol, gambling, tobacco)
• Weapons (chemical & biological, cluster munitions, anti-personnel mines, nuclear, conventional military weapons, civilian firearms).

Companies that don’t conduct themselves well in the following areas are removed from the index:

• Anti-corruption
• Environment
• Human rights
• Labour
• Board diversity and equal opportunities practices.

This second list could be considered quite subjective so FTSE has a detailed document you can download if you’re interested in more detail.

A further twist in the story is that not all of the ESG benchmarks exclude all of the categories. The ESG benchmark funds that are available in the UK do not have companies removed based on board diversity and equal opportunities practices.

FTSE apply the above criteria to create a list of companies that fit this profile. This is the list or index that then Vanguard base their fund on and then Vanguard try to mirror this as closely as possible. This is how you end up with the index funds that we buy!

If you’re interested in getting super geeky – read our high level article about how benchmark indexes are created.

​FTSE versus MSCI differences

In Katie’s research she discovered that even at a country level the two different benchmark indexes treat countries differently.

FTSE says that Poland and South Korea are developed countries and MSC I says they are emerging markets. They can’t even agree on what a developed country versus an emerging market country is!

For more on the difference between developed countries and emerging markets, Katie and I have written and researched an article for you entitled “How Global is your Global Index Fund?”

What is the difference between an ESG fund and a Standard fund?

To understand the differences between the standard fund and the ESG fund Katie has analysed the global benchmark funds as provided to Vanguard by FTSE. She found that in the standard global benchmark there are 9,153 companies. Then 1,182 companies are removed to arrive at the ESG global benchmark. That’s 13% of companies being removed. Sounds like a lot! The graph below shows the number of companies removed by country.

You start at the left with the total number in the standard benchmark and then each orange bar is taken away until you get to the ESG benchmark in grey on the right.

Looking at the number of companies doesn’t tell the whole story because not all companies are weighted equally in the index. Overall nearly 18% of companies are removed based on their weighting. 18% feels a lot of companies to be removing! This means that FTSE thinks that 18% of the companies we can invest in through the standard benchmark are not ethical, sustainable or well governed. Let’s look at a similar chart but based on the company’s weighting in the index rather than just the number of companies to illustrate this.

You can see that 8.4% of the companies in the USA by weight are removed from the index; then 1.4% from the UK and so on.

Who are the naughty boys and girls?

The two graphs tell slightly different stories in terms of which companies are excluded from the ESG index. In the first graph it looks like USA, China and Japan are the biggest culprits with 236, 172 and 118 companies removed from the standard benchmark respectively.

Now looking at the second graph… USA, UK and France are top of the naughty list since they account for the biggest chunks of the pie being removed (8.4%, 1.4% and 1.2% respectively).

But this doesn’t tell the whole story! A more meaningful thing to look at is how much each country contributes to the companies excluded and how that compares to how much that country is in the original benchmark.

For example, of the companies removed from the index, the USA accounts for 47% of them by weighting. Wow, you’re saying that nearly half of the companies on the naughty list are from the USA?! Sounds like they’re super naughty doesn’t it. But in the standard benchmark, 57% of the companies are from the USA so you could argue that actually they’re less naughty on average!

What about the industries that are excluded from the benchmark?

The following graphs show the companies that have been excluded from the ESG benchmark index based on what sector they’re in. First by number of companies and secondly by the weighting of the companies in the index.

So you can see the standard benchmark index on the left and then the first orange bar to the right shows 269 companies in the industrial good and services sector have been removed; then a further 266 companies from the energy sector (this is going to be a lot of oil, fossil fuels and non-renewable energy companies).

This time the top 4 “naughty” industries are the same whichever way you look at it as summarised in the table. The final column shows you how much those companies account for, of the excluded companies. For example, the industrial goods and services companies that have been removed are 21% of the excluded companies by weighting.

Visualising the ESG funds and what gets excluded

Katie and I really wanted to get geeky and visualise what actually gets removed from the standard indexes to arrive at the ESG indexes. Katie downloaded the data for the Emerging Markets benchmarks and the Global benchmarks and analysed each of these in turn.

Emerging Markets benchmark

This first set of charts analyses the standard benchmark index and the ESG benchmark index for Emerging Markets. In the graph below, you can see the countries that make up the markets (China is the biggest bar). Each bar is split into two colours, blue and orange. The blue shows the companies that remain in the ESG index and the orange shows the ones that where removed from the standard fund. The total bar shows the total number of companies in the normal fund.

The things I noticed in this first chart is that the fund is dominated by three main countries, China, India and Taiwan. By sheer number of companies, China and India have had the most removed in the ESG fund.

​The graph to the right shows the same data but weighted by company market cap rather than absolute number of companies.

Then the final chart here Katie created for the emerging markets fund shows a fascinating look at what percentage of each country is removed by weighting.  This shows you what percentage of the countries companies in the fund (by size) have been removed as they fail to live up to the ESG funds standards!

This gives you the real “naughty” list of countries!

Naughty Emerging Market List

If Santa had a list and he was checking it twice these countries would only be getting a lump of coal for Christmas!

1. Russia – had 67% of its companies removed from the index
2. Czech Republic – 53% of companies
3. Brazil – 37% of companies
4. Colombia and the Philippines are tied with 31% removed

Emerging markets by industry

The next three charts show the same emerging markets fund but by industry rather than country. The first chart shows number absolute number of companies. You can see that Energy had 111 companies removed, Industrials had 84 companies removed and then Basic Materials had 55 companies removed.

The next chart shows the same data but by weighting rather than absolute number of companies.  You can see that 93% of Energy companies were excluded from the ESG benchmark index for Emerging Markets.

The final chart for the emerging markets shows the data as a percentage of each industry.  I think this really highlights the industries that are most heavily excluded from the index. 

What gets removed from the global ESG fund?

Here is the next set of super exciting charts from Katie! Yay. She has gone away and analysed the global benchmark to see what comes and goes between the standard version and the ESG version.

The first chart shows number of companies by country. You can see clearly the top three countries, USA, China and Japan have the most companies in the index. The full bar represents the total number of companies in the global benchmark and then the orange shows you what is excluded to get down to what is left in the ESG fund (blue).

This second chart really brings home what a huge percentage of the global fund is made up by the USA. If this surprises you then you need to read our article: How Global is your Global Index fund. The graph shows the companies in each country by weighting of company.

If you were looking at this graph in isolation then you would think that the USA has a really big proportion of companies excluded from the ESG fund and should be on the very naughty list. However, the following chart shows it as a percentage of the companies in that country by weighting and you will be surprised to find out where the USA actually is in the rankings!

The following chart looks at each country and shows how much of that country gets excluded from the ESG fund based on the size of the company. The bigger the orange bar the more of that country’s companies is removed based on size. The USA is way down the list in 32nd position!

Santa’s naughty list for 2022 was:

1. Russia
2. Portugal
3. Spain
4. France
5. Italy

These are the countries that had the most excluded from the ESG fund by weighting! What I got from this is if I just bought the USA total stock market I am actually buying one of the better nations in terms of ESG companies. I would not have imagined that.

The global fund by industry

These next 3 charts show the same data for the global standard benchmark fund but by industry. You can see that by sheer number of companies industrial and energy have had the most companies removed from the index.

When you analyse the data by weighting (value of the company) you can truly see how much of the energy sector is removed from the fund.  Nearly all of this sector is excluded from the ESG fund.

Showing the same data but as a percentage of the companies removed by weighting from the fund you can see clearly 93% of the energy sector is removed from the fund!  56% of the utility companies are excluded from the global ESG fund as well. 

The main things I got out of looking at these charts is that the criteria applied really do distort what sectors and countries the ESG funds end up investing in.  Katie and I are HUGE believers in index funds and the fact you can’t beat the average returns of the market over the long run.  I can’t help feeling that ESG funds distort this and are going to lead to worse performance over the long run.

Big hitters excluded from the ESG funds

We were curious to look at a company level and to see how many of the big companies in each country have been removed from the ESG funds. So we looked at the top ten by market cap to see what was taken out!

We were shocked by the results in the UK. Here is a list of the top 10 companies in the UK index by market cap.

1. AstraZeneca
2. Unilever
3. HSBC Hldgs
4. Diageo
5. GlaxoSmithKline
6. BP
7. British American Tobacco
8. Rio Tinto
9. Royal Dutch Shell A
10. Royal Dutch Shell B

How many of those do you think are removed from the ESG fund? Can you guess which ones get stripped out? They are removing non-renewable, vice and weapons.
The answer is that 7 are excluded from the ESG fund and all but 3 remain! These are the only 3 that remain in the ESG fund.

1. ​AstraZeneca
2. Unilever
3. GlaxoSmithKline

Seems like the UK is a hot bed for illicit and bad companies! They removed 7 of the 10 biggest companies from the UK top ten. This is insane. Seven of the biggest drivers of the UK economy have been removed. You have taken out 7 of the most profitable, largest companies from our index. These companies account for 21% of the UK companies in the standard global fund by weighting. Overall, 63 UK companies are excluded from the ESG benchmark and these account for 36% of the UK companies in the standard global fund by weighting. Meaning that you are excluding over ONE THIRD of UK companies from the ESG benchmark.
This concerns me massively. If I buy the ESG fund I think that I am getting a strong ethical fund but I am not told that I am giving up some of the largest drivers of the economic engine in the UK! Did you know this? Are you willing to do this?
Katie and I don’t drink alcohol but we have no problem anyone else drinking it and yet the ESG fund automatically strips out Diageo (Johnny Walker, Guinness, Baileys etc.) from the fund because it sells alcohol.

Which brings us to the crux of the matter; what makes an ethical, sustainable company is subjective. Some people will decide they have no problem with alcohol companies and others think they are evil.

This is looking more and more like stock picking.

Do ESG funds outperform standard index funds?

Do ESG funds outperform standard index funds? This is the biggest question and one of the assumptions I have about them.

I started googling if they were more profitable or not and the first few articles I found seemed to show they were. I found an article “Here’s more evidence that ESG funds outperformed during the pandemic” which I read first.

I had several problems with the article. The first was the short time frame. We are investing for decades not 18 months which the article covers. There are always going to be ups and downs where one sector out performs and others do badly. This is normal. I am not looking for short term data. I want longer data.

The thoughts that then came to me were “when were ESG index funds created” and “what’s the longest time frame I can compare over”? So I started to search for the longest running ESG funds.

I managed to find 10 year data on the Friends Provident Stewardship fund that we can compare to the standard Vanguard index that Katie and I invest in.

if you had invested £10,000 in the Friends Provident that would have grown to £20,955 by December 2021. Not bad I hear you saying! Doubling my money in 10 years is pretty good.

Sounds good but when you compare it to the Vanguard FTSE Developed World ex UK fund that Katie and I invest in; it doesn’t look good. £10,000 invested in the fund we invest in would have grown to £37,596 over the same period; almost quadrupling.

I hear you screaming “money isn’t everything Alan!”

And you are right, money isn’t everything but that kind of growth can mean the difference between hitting financial independence and not. It can mean the difference between having enough to retire or not.

I would rather have the extra profit and then spend it on doing good in the world!

I have compared the Vanguard Dev World with the Vanguard ESG Developed World All Cap and the results are interesting. £10,000 invested in the ESG fund would have returned £35,231 over the same 10 year period which is pretty good!

Now you are only talking about a difference of 24% over 10 years. That is still significant. Depending on how tight your income is it could affect your progress but it is a price you might be willing to pay for ethical investing.

We have looked at past performance and as every single advert for investments tells you “Past performance is no guarantee of future growth!” So the question becomes which fund will do best in the future?

I don’t know if ESG funds will outstrip standard funds in the future or continue to underperform them. The one thing that I can tell you is that if the ESG companies outperform the non-ESG companies then they will naturally make up a bigger and bigger percentage of the standard index anyway.

If you bet on the total index you will see the upside of the ESG companies but if you bet ESG you will not see any upside from the non-ESG companies as they are by definition excluded from your index.

From the research I have done for this article my conclusion is that the further you stray from the principles of index investing the worse performance you get. What I mean by that is the more you go towards the stock picking end of the spectrum the worse percentage return you get on average over the long term.

​Just on a purely monetary decision I would not move from a standard index fund.

What do other FI authors think of ESG funds?

On Rebel Finance School we had three special guest speakers, Mr Money Mustache, JL Collins and Millennial revolution. Here is a very brief overview of what they told us on the course.

• Mr Money Mustache invests in ESG funds and the mission behind his blog is an environmental one.
• JL Collins believe ESG funds are a form of stock picking and does not invest in them. He invests in the US total Stock Market Vanguard Fund.
• ​Millennial revolution also believe the funds are stock picking and as such don’t include them in their portfolio.

Did writing this article changes our assumptions?

​Here are Alan’s assumptions from before writing this page and whether he has changed them:

1. An ESG fund is a standard index with a bunch of stuff removed. We have confirmed this is true!
2. It is a form of stock picking because someone is deciding what an ESG company looks like and picking what is a good company. Humans have gone through the list of stocks available and decided what is an ESG stock or not and excluded a huge number of stocks. My opinion hasn’t changed here.
3. The criteria are a bit obscure and I am not entirely sure what I am buying when I get one of these funds which makes me nervous to buy them. Now I do know what I am buying if I get an ESG fund. I have seen what they have stripped out and how they make their decisions. I used to be nervous to buy an ESG fund because I didn’t really know what it is but I know what they are now so I’m not nervous (spoiler alert… I still don’t want to invest in them).
4. Investing my money into ethical companies won’t actually make a difference. What will make a difference is if consumers (you ,me and the others) shift their spending and buy products from ESG companies. Having researched ESG funds and debated this endlessly with friends and experts I am even more convinced of this point. If I truly want to make a difference in the world then I need to change my spending habits and persuade other people to do the same. If I can do this then it will have a far greater impact than if I change where I invest my money.
5. These funds will perform worse over time compared to traditional index funds because of the above reasons. From my initial research this seems to have been proved to be true. The more extreme the ESG criteria, the worse the performance over the long term. The broadest based ESG funds seem to perform the best. They still don’t perform as well as the standard index.

Will investing in ESG funds make a difference? Our thoughts

This is where it becomes difficult. No one really knows. I am going to give you my opinion.

At the annual Rebel Retreat one of the Rebel Board members started discussing ethical investing and how he was getting involved in several actively managed ethical funds. He felt like he was doing the right thing for the environment and helping people to invest ethically. I felt like he was tackling the problem from the wrong end.

In my opinion if you want to have the most impact on the environment you should change the way you spend your money not how you invest your money.

If there is a company that we can all agree is bad for the environment and is causing problems and we all decide not to spend money with them what will happen to that company?

They will either go bankrupt as they will lose all their income or they will change their ways pretty quickly, tell the world they are now ethical and sustainable and start to sell what the market actually wants.

If we change our investment and don’t invest in that company but it still has all its customers and is making a decent profit then what happens to that company?

Nothing. it will continue to trade because it can make a profit. Over the decades, humans have clearly shown that if they can make a profit doing something they will. If they can’t make money doing something then they won’t.

If you want to change the world then change where you spend your money and persuade other people to change where they spend their money. This will have a BIGGER and faster impact than “ethical” investing every will.

If we all changed to spending money with “ethical” companies then the main index would change to reflect that in a matter of months.

Having thought a lot about this and argued the point with a lot of people my thoughts are:

• Change your spending and that will change the index make-up automatically
• Changing your spending will reduce the profits of unethical companies
• Persuading other people to change their spending will have an even bigger impact on the companies profits and thus their behaviours
• ​Boycott companies that are unethical. This will have a huge impact if enough people do it. You can change a company’s behaviour if enough people hit its bottom line.

I am not convinced that by me shifting my money to an ESG fund will actually have the impact that people hope it will have.