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ETF Specialist

Unintended Biases in ESG Index Funds

ESG index strategies can be effective tools for values-based investing, but they may introduce some additional bets that investors may not intend to make.

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A version of this article was published in the May issue of Morningstar ETFInvestor. Download a complimentary copy of Morningstar ETFInvestor by visiting the website

Environmental, social, and governance investment strategies can help many investors better align their money with their values. These strategies generally target firms that have a limited negative impact on the environment; promote diversity and have good relationships with key stakeholders, including employees; and strong corporate governance that promotes accountability. Many also exclude companies in certain lines of business such as tobacco, alcohol, and gambling. But there is a risk that this focus might introduce unintended sector or style bets, particularly among index funds. Differences in construction methodology can cause some strategies to have larger unintended biases than others.

Take  Vanguard FTSE Social Index (VFTSX), for example. It tracks the FTSE4Good US Select Index, which starts with the broad large- and mid-cap focused FTSE USA Index, but excludes firms which generate a nontrivial part of their revenue from the production of coal, weapons, tobacco, gambling, adult entertainment, and nuclear power. Qualifying stocks must also meet minimum standards for diversity, and cannot be involved in a controversy in several key areas, including environmental management, labor rights, human rights, and health and safety. Stocks that make the cut are weighted by float-adjusted market capitalization and there are no sector-weighting constraints. 

The resulting portfolio has greater exposure to the technology, financial services, and healthcare sectors than the Russell 1000 Index, and less exposure to telecom, energy, and industrial stocks. The technology overweighting isn’t surprising, as these companies tend to have a smaller environmental impact than average. These sector tilts may be unintentional, but they can affect the fund’s relative performance. And they are not uniform across all ESG strategies.

For instance,  iShares MSCI KLD 400 Social (DSI) has greater exposure to consumer defensive, telecom, and energy stocks than the Vanguard FTSE Social Index, and considerably less exposure to the financial services and healthcare sectors, as table 1 illustrates. This is because the MSCI KLD 400 Social Index, which DSI tracks, applies more positive ESG screens and uses a sector-relative ESG rating system. In contrast, FTSE applies the same requirements across all sectors. As a result, only about half of Vanguard FTSE Social Index’s portfolio is represented in the MSCI KLD Index. Like the Vanguard fund, the MSCI index weights its holdings by market capitalization, but it explicitly limits its sector tilts to within 25% of the corresponding figures in the MSCI USA IMI.

 iShares MSCI USA ESG Select (KLD) goes further to mitigate unintended bets. It uses an optimizer to construct a portfolio that emphasizes stocks from the MSCI USA Index with strong ESG characteristics (based on the same ESG rating system that the MSCI KLD 400 Index uses) under a set of constraints. These include limiting sector tilts to within 3 percentage points of the broad market-cap-weighted MSCI USA Index, keeping estimated tracking error against that index under 1.8% and individual stock weightings under 5%, and limiting turnover. This index fund applies fewer outright exclusion rules than DSI and Vanguard FTSE Social Index, only explicitly excluding tobacco firms, but its focus on ESG ratings effectively keeps it away from the same types of companies that its peers exclude.

As a result of its sector and tracking error constraints, KLD tends to look more like the market than its peers, as table 1 shows. Of the three funds, it does the best job mitigating active bets that are not directly related to ESG.


Sector weightings aren’t the only differences between these funds. Vanguard FTSE Social Index has been a bit riskier than its peers. It exhibited greater volatility and market sensitivity (beta) than DSI, KLD, and the Russell 1000 Index from December 2006 (the first full month that data for all three funds are available) through May 2016. This was partially due to its large overweighting of financial services stocks, which also gave the Vanguard fund a slightly greater value tilt than its peers. At the end of May, its holdings were trading at slightly lower average multiples of forward earnings and book value than its peers, as table 2 shows.


These differences aren’t inherently good or bad, but they aren’t obvious given the similarity in the funds’ mandates. It is important to look under the hood to understand the bets each fund is making.

Negative Versus Positive Environmental Screens
A deep dive is also necessary to determine whether a socially conscious fund’s investments are consistent with your objectives. Consider  SPDR S&P 500 Fossil Fuel Free ETF (SPYX), which invests in the members of the S&P 500, excluding those with fossil fuel reserves. Not surprisingly, this causes the fund to have an underweighting to the energy sector. But it still includes energy equipment and service providers, like  Halliburton (HAL), and oil refiners including  Valero (VLO) and  Phillips 66 (PSX). Because these holdings are still involved in the production of fossil fuel products, their inclusion may be inconsistent with investors’ expectations for the strategy. ProShares S&P 500 ex-Energy (SPXE) addresses this issue by entirely excluding the sector.

Yet, neither fund considers how much fossil fuel its portfolio companies use in their operations or their carbon footprints. Investors who are concerned about greenhouse emissions may be better served by iShares MSCI ACWI Low Carbon Target (CRBN). It tracks an index that uses a constrained optimizer to emphasize stocks from the MSCI ACWI with low carbon emissions relative to sales and low potential emissions (from fossil fuel reserves) relative to market capitalization. The constraints limit tracking error relative to the MSCI ACWI to 30 basis points and keep country and sector tilts within 2 percentage points of the index (with the exception of the energy sector, where there is no constraint). As a result, the fund tends to look a lot like the market. And it still includes energy equipment and oil refining stocks, like SPYX, which may be a turnoff to some investors. However, its more holistic focus on emissions could make it a more compelling option.

Sustainable Impact
While most ESG funds target stocks that score well on several dimensions of environmental stewardship, social consciousness, and governance in their normal course of business, few explicitly target firms whose primary business objective is to advance social interests. Recently launched iShares Sustainable MSCI Global Impact (MPCT) attempts to do just that. It invests in companies that generate at least half of their revenue from activities that address the social and environmental challenges outlined by the United Nations' Sustainable Development Goals. Their operations also have to meet minimum ESG standards. Table 3 lists the development goal categories.


The fund weights its holdings by the revenue they generate from these sustainable impact categories, adjusted by the ratio of their free-float market capitalization to total market capitalization. It caps sector weightings at 20% and individual positions at 4%. The portfolio is rebalanced annually and reviewed quarterly.

This strategy represents a logical progression in ESG investing. However, it introduces some indirect active bets that investors may not expect. For example, it currently has greater exposure to industrials, utilities, healthcare, and consumer defensive stocks than MSCI ACWI. It also has underweightings to financial services and technology stocks and currently has no exposure to the energy or telecom sectors. On top of these sector tilts, the fund has a slight growth bias, a smaller-cap orientation than the MSCI ACWI, and less exposure to U.S. stocks.

It is difficult to for this type of strategy to avoid these inadvertent bets because most stocks do not meet its demanding selection criteria (it currently holds fewer than 100 names). And these bets aren’t necessarily bad. In constraining a portfolio to look more like the market, investors must own some companies with less-attractive absolute ESG characteristics than an unconstrained portfolio. This is a trade-off investors make. Those who do take a less constrained approach should be mindful of potential unintended bets and be comfortable with their potential impact on performance.


  • ESG funds with similar mandates can have very different portfolios. Unconstrained funds often introduce active bets that ESG investors may not intend.
  • Constrained funds, like KLD and CRBN, mitigate active bets that are not directly related to ESG. But these constraints may also increase the funds’ exposure to firms with less desirable ESG characteristics.
  • Investors can go beyond traditional ESG investing with MPCT, which invests in companies whose primary business is related to the advancement of key social interests.
  • Check whether each fund’s approach is consistent with your objectives. Strategies that exclude some stocks, like those with fossil fuel reserves, may still have exposure to others with undesirable characteristics, like large carbon footprints.



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Alex Bryan does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.