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Just how green is your ‘green’ fund?

March 31, 2021, 10:30 AM UTC
INV.05.21.ilo
Can you trust your ESG mutual fund?
Illustration by Seb Agresti

In investing, powerful emotions drive people’s decisions. And nowhere was that more true in 2020 than in environmental, social, and governance (ESG) stock funds—where investors’ passions, fears, and hopes about the state of the planet fueled a record-shattering year. 

ESG funds promise to steer their assets toward companies that avoid harm or do social good. And as the world reacted to COVID-19 lockdowns, social unrest, and ecological disasters, money flowed into these funds faster than oil sprays out of a broken pipeline. Net new investment reached $51.1 billion in 2020, according to Morningstar—more than double the record set the previous year. And even as stock markets did unexpectedly well, ESG investors did even better: In the U.S., the median sustainable fund outperformed its traditional peers by more than four percentage points. 

These numbers in part reflect a long-term trend of investors aligning their assets with their values: About one of every three dollars invested in funds now goes toward “sustainability vehicles,” according to the Forum for Sustainable and Responsible Investment. (ESG funds are generally labeled “sustainable,” even when they focus more on social or governance issues than on the environment.) But would-be do-gooders now face a quandary: As ESG investing grows more popular, more funds are sprinting to adopt the label—whether or not they’re working hard to earn it.

According to research by founders of the ESG consulting firm KKS Advisors, more than 6,600 funds now identify as “ethical,” twice as many as in 2013. In the European Union, under rules that began to take effect in March, funds that market themselves as ESG-oriented must disclose exactly how their strategies help solve social problems. But there’s no such regulation in the U.S.—so the onus is on investors to separate substance from hype. 

So how should you vet this sprawling field of suitors? As with any funds, start by assessing performance and fees. To narrow your options further, it helps to understand the industry’s subcategories and see which ones align best with your investing style. With no set rule for sustainable designs, funds have adopted “a collection of approaches,” says Jon Hale, U.S. head of sustainability research for Morningstar. Investors can do the same, mixing and matching among these three styles: 

The shunners

The most basic ESG methodology focuses on avoiding bad actors. Managers of most funds will look at a given investing universe—say, U.S. large-cap stocks—and disqualify those that rank at the bottom third of a given ESG factor, like environmental impact or fair treatment of employees. (There’s a whole subindustry geared to creating such rankings.) A fund’s prospectus should explain how its managers decide who’s in and who’s out.

Some ESG funds invest with a conscience by dropping disqualified stocks and holding almost everything else. One strong performer in this category is Vanguard FTSE Social Index Fund Admiral Shares (VFTAX). It tracks the FTSE4Good U.S. Select Index; in mid-March, it owned 468 large-cap U.S. stocks. It returned 23% last year, compared with 18% for the S&P 500, and annual expenses are just $14 per $10,000 invested. 

The seekers

Other funds focus more selectively on top performers among the non-excluded stocks. And some of their managers are not only active stock pickers, but also activists—using their shareholder votes to seek change at companies in which they invest. These funds often publish “engagement reports,” outlining the issues they have addressed with company management, along with roundups of their proxy voting activity. Some go further and publish impact reports, outlining exactly how their investment strategy is intended to have a positive effect. Those reports “should be considered a best practice,” says Morningstar’s Hale—a sign of a fund company that’s committed to its mission. (Another sign of commitment: An active fund’s managers should have extensive previous experience in ESG investing.)

The number of funds that categorize themselves as “ethical” has doubled since 2013.

San Francisco-based Parnassus Investments is a veteran in ESG stock picking, and the Parnassus Core Equity Investor (PRBLX) fund has been a top performer since its inception in 1992, with average annual returns of 11.4% (and 21% in 2020). Comanager Todd Ahlsten has helmed the fund since 2001, and his team has been both savvy at stock picking and conscientious about social causes. For example, Parnassus recently helped persuade snack giant Mondelez to use more recyclable packaging. 

The specialists

Jennifer Kenning is the CEO of Align Impact, which works with individual clients and financial advisers to build sustainable portfolios. One of her key pieces of advice for passionate investors: Instead of researching the entire ESG landscape, focus on “one thing you can move the needle on.” The massive proliferation of ESG funds, especially ETFs, has made it easier to target a specific cause: Investors can focus on backing clean technology (the many options include iShares Global Clean Energy, ICLN); supporting women-friendly companies (SPDR SSGA Gender Diversity Index, SHE); or even avoiding animal exploitation, including companies that make or sell meat-based products (U.S. Vegan Climate, VEGN).

One reason ESG funds in general outperformed the broader market in 2020 is that few of them own fossil-fuel stocks, which generally tanked last year. But clean energy is a narrower focus whose long-term outlook remains strong. Two promising ETFs in the space share a comanager: Peter Hubbard, a 14-year ESG veteran, oversees both Invesco Solar (TAN) and Invesco WilderHill Clean Energy (PBW). TAN holds about 50 primarily solar-focused companies, with 20% of the fund split between the U.S. company Enphase Energy and Israel’s SolarEdge Technologies; PBW invests in a broader range of energy firms. While their investors may never outdo 2020, when shares in both ETFs rose more than 200%, they’re likely to keep benefiting from an economy that’s gradually embracing the imperative of getting greener.

This story appears in the April/May 2021 issue of Fortune.