Fossil-fuel energy stocks roared back in 2021. That could have spelled doom for the performance of sustainable investment exchange-traded funds — but about half of the largest ESG offerings did better than versus the S&P 500.

But like with many funds, stock selection, rather than sector bias, is the main reason, said Todd Rosenbluth, director of ETF research at CFRA.

Many of ESG ETFs held some of the biggest technology names that also helped to power the broad indexes, such as Apple AAPL, +0.51%, Amazon AMZN, +0.57%, Tesla TSLA, +1.75%, Nvidia NVDA, +1.38% and Microsoft MSFT, +1.77%. Weightings also mattered; some were overweight a few key names versus the broader index SPX, +0.08%.

The technology sector climbed about 35% in 2021, and it’s the largest sector in the S&P 500 at 29%. Energy, meanwhile, is among the smallest S&P 500 sectors at 2.7%, which muted the influence of its 53% surge. The S&P 500 had a total return of 28.7% last year.

Rosenbluth said there was a perception that the broad-based ESG ETFs would be missing out amid the energy sector’s rally. He knew that was wrong “because energy is such a small piece of the broader market, it wasn’t going to be that detrimental to their performance.”

Several of the largest ESG ETFs are sector-neutral funds, which are designed to have similar exposure to whatever broader market exposure they track and could be substitutes for traditional core holdings. Energy companies can sometimes be included in ESG ETFs if they have high social or corporate governance scores.

Owning energy names didn’t always lead to outperformance. The best example of that is iShares ESG Aware MSCI USA ETF ESGU, -0.09%, the largest ESG ETF by assets under management at $25.7 billion, has a 2.9% weighting to the energy sector, slightly more than the S&P500. It gained 26.7%, lagging behind the S&P’s gains.

“They might not own some of the better-performing energy companies that might have scored worse from an ESG perspective,” he said.  

Lukas Smart, head of U.S. iShares sustainable and factor strategies at BlackRock BLK, -2.19%, said the asset manager believes sustainable portfolios “can provide better long-term risk-adjusted returns to investors as society navigates the transition to a low carbon economy.”

He added that BlackRock’s suite of ESG ETFs gives “all investors more choice in how they want to meet their investment objectives and sustainability goals.”

While that iShares ETF slightly lagged the broader market, others among BlackRock’s ESG funds outpaced the S&P. They include the $4.39 billion iShares MSCI USA ESG Select ETF SUSA, -0.20%, which has a 1.35% energy weighting; the $4 billion iShares ESG MSCI USA Leaders ETF SUSL, +0.15%, with a 1.16% energy weighting; and the $4 billion iShares MSCI KLD 400 Social ETF DSI, +0.01%, with a 0.94% energy weighting. All three returned at least 30%.

Among other broad-based ESG ETFs with energy underweights, Xtrackers MSCI U.S.A. ESG Leaders Equity ETF USSG, +0.12%, a $3.8 billion fund, has only 1.2% energy exposure, ended 2021 up 31.8%.

Vanguard ESG U.S. Stock ETF ESGV, -0.06%, the second-largest ESG ETF by AUM at $4 billion, only has 0.25% invested in the energy sector. It rose 26.6% in 2021, slightly trailing the S&P but closely tracking its benchmark, the FTSE US All Cap Choice index, which comprises 1,500 securities.

Change Finance U.S. Large Cap Fossil Fuel Free ETF CHGX, -0.30%, a $117.5 million fund whose only energy exposure comes from solar panel maker Sunrun RUN, -2.90%, rose 28.4%. Nuveen ESG Large-Cap Growth ETF NULG, +0.02%, a $913 million fund that has just 0.4% in energy, rose 28.2%.

“It highlights how you could still have done well from a fossil-fuel-free perspective, just because energy is so small,” Rosenbluth said.

How broad-based ESG ETFs stacked up in 2021
Name
Ticker
2021 return
AUM, in billions of $
iShares ESG Aware MSCI USA
ESGU
26.70%
$25.70
Vanguard ESG U.S. Stock ETF 
ESGV
26.60%
6.4
iShares  MSCI USA ESG Select ETF
SUSA
30.50%
4.8
iShares ESG MSCI USA Leaders ETF
SUSL
31.50%
4.3
iShares MSCI KLD 400 Social ETF 
DSI
31.30%
4.2
Xtrackers MSCI U.S.A. ESG Leaders Equity ETF 
USSG
31.80%
3.8
Xtrackers S&P 500 ESG ETF 
SNPE
31.40%
0.9
Nuveen ESG Large-Cap Growth ETF 
NULG
28.20%
0.9
iShares ESG Advanced MSCI USA ETF
USXF
27.10%
0.6
IQ Candriam ESG US Equity ETF 
IQSU
30.50%
0.5
SPDR S&P 500 ESF ETF 
EFIC
31.30%
0.5
Change Finance U.S. Large Cap Fossil Fuel Free ETF
CHGX
28.40%
0.1

S&P 500
SPY
28.70%
Source: CFRA Research, MarketWatch

Stock selection

Rosenbluth says stock selection was why some of the ESG ETFs perform strongly. While the top holdings in iShares and Vanguard ETFs are weighted similarly to the holdings in the S&P, the Nuveen and Xtrackers ETFs were overweight Microsoft, Tesla and Nvidia, but had no exposure to Amazon and Apple. Change Finance was underweight the top technology names, suggesting other stock holdings impacted performance.

Fund
Exposure to mega-cap stocks (% of assets)*
Apple
Microsoft
Amazon
Tesla
Nvidia
iShares ESG Aware MSCI USA
6.6
5.6
3.5
2.2
1.8
Vanguard ESG U.S. Stock ETF 
6.8
6.1
3.6
2.1
1.7
Xtrackers MSCI U.S.A. ESG Leaders Equity ETF 
10.7
4.24
3.3
Nuveen ESG Large-Cap Growth ETF 
11.5
3.9
3.8
Change Finance U.S. Large Cap Fossil Fuel Free ETF
1.04
0.95
0.85
iShares  MSCI USA ESG Select ETF
5.6
4.59
2.1
2.5
iShares ESG MSCI USA Leaders ETF
10.4
4.2
3.2
iShares MSCI KLD 400 Social ETF 
9.9
4
3

S&P 500
6.8
5.9
3.6
2.2
1.7
*As of Jan. 13, 2022

That’s a reminder for investors to not just look at a fund’s 10 largest holdings, but to review all of an ETF’s holdings, he said. People usually buy ESG ETFs for the “do good” reasons, but may there may be fundamental benefits to the companies they include or exclude.

“We contend all of the stocks included and excluded from an ESG ETF, not just the top-10 positions, matter more than the fund’s expense ratio or its assets under management, though we think many people choose an ETF based on such metrics,” he said.

All of these ESG ETFs are passive index funds that follow preset rebalancing rules, he noted. That means the heavier weights to certain highfliers aren’t a sign of goosing returns. Companies in ESG index ETFs are generally selected because they score high from an ESG perspective, not on valuation or momentum characteristics.

“They got lucky in that the stocks they favorably weighted, or overweighted happened to be some of the higher-flying stocks,” he said.

Debbie Carlson is a MarketWatch columnist. Follow her on Twitter @DebbieCarlson1.

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