power your advice

Technology Stocks Should Be Prominent in ESG Portfolios

Written by: Dan Roarty

The Wall Street Journal criticized ESG portfolios earlier this month for being dominated by big technology stocks. But we think technology stocks are integral to a responsible investing agenda when chosen as part of a well-defined process targeting companies that foster environmental, social and governance (ESG) improvements.

According to the WSJ article, published on February 10, sustainable investing funds are guilty of false marketing because they don’t necessarily invest in companies that sell wind turbines or promote diverse boards. “Many of them look a lot like a portfolio of big technology stocks,” the author wrote.

Citing a report by RBC Capital Markets, the WSJ noted that the five most commonly held S&P 500 stocks in actively managed sustainable equity funds are Microsoft, Alphabet Inc., Visa, Apple and Cisco Systems. Companies like NextEra Energy, the world’s largest operator of wind and solar farms, are underrepresented in ESG funds. These findings, the report says, reflect a major frustration of socially conscious investors because the industry lacks a rulebook for ESG funds.

Three Mistakes

The report misses the mark on three fronts, in our view. First, it advocates a very narrow definition of ESG issues and funds. Second, the report fails to acknowledge the central role technology companies play in driving ESG improvements. Third, the article fails to recognize the alpha opportunities that active managers have when owning competitively advantaged companies focused on sustainability.

What Are ESG Issues?

Socially driven investors want to help make the world a better place. But expecting sustainable funds to only invest in companies that “fight climate change, develop wind turbines or promote diverse boards” is a mistake, in our view. It’s also a common misunderstanding. Many investors are grappling with defining ESG issues. The article implies that only a narrow list of ESG issues are legitimate, but the opposite is true. Sustainable development touches all facets of society.

We believe that the UN Sustainable Development Goals (UNSDGs) provide investors with a good guide to defining the full scope of sustainable issues and investment opportunities. The 17 goals, developed by 193 developed and developing nations, address the world’s most pressing issues, including poverty and inequality, gender, access to healthcare, financial inclusion and clean energy. These issues impact individuals and companies in all geographies and all economic sectors, highlighting the fact that ESG issues are anything but narrow.

The WSJ article also conflates two distinct drivers of social value creation—products and corporate behavior. In general, a company can create or destroy social value through its products and services (wind turbines versus tobacco, for example) and via its own operational behavior (fair gender pay versus corruption and bribery, for example). ESG issues apply equally to both categories.

What Is an ESG Fund?

It’s true that there is no set definition of what qualifies as an ESG fund, as the WSJ noted—and as the SEC has noticed. It’s also true that ESG funds come in all shapes and sizes. But that doesn’t mean all ESG funds are guilty of “greenwashing.”

Clarity and transparency matter. Investment managers must have a clearly articulated methodology for incorporating ESG factors. Clients deserve to know exactly how a manager’s approach impacts portfolio construction, characteristics and expected returns.

ESG strategies can take many different approaches, which affects portfolio construction. Some intentionally target companies selling socially beneficial products and, as a result, will typically overweight certain industries like healthcare, technology and industrials. Other funds focus on engaging companies with poor ESG behaviors to capture the alpha that comes with improving practices; these funds may invest in any sector—including in companies like utilities that don’t typically pop up on ESG radar screens.

Companies that sell products or services to help accomplish one or more of the UNSDGs and that have strong fundamental businesses make for attractive investment candidates, in our view. This type of focus results in a quality growth-oriented portfolio. But there are other ways to apply an ESG focus, and investors can choose which of these is the most suitable for their individual investment needs.

Why Shouldn’t ESG Funds Own Tech Stocks?

The WSJ implies that owning big tech stocks is incongruous with an ESG-focused agenda. But why? Technology companies help us communicate and share knowledge, create new employment opportunities, fuel economic growth, extend the reach of healthcare, connect people and small businesses to the financial system, and protect our personal digital assets. Each of these issues is at the heart of sustainable development. It would be strange, we think, to ignore them in an ESG fund.

Of course, tech companies face growing concerns over ESG issues such as data privacy, corporate governance and data-center energy consumption. These are areas where an active equity investor can engage with management and, based on the research engagement, determine whether to own that stock. So, investors with a clear definition of sustainability can identify technology stocks that can be powerful vehicles for positive change and exclude those who don’t meet their criteria.

The Closet Indexing Concern

Perhaps ESG funds are all just out to dupe investors and mimic the benchmark? The WSJ argues that ESG funds have big weights in big tech because they’re concerned about deviating too far from the benchmark, which adds underperformance risk. We think it’s unfair to single out sustainable funds for closet indexing, which is an industrywide problem.

In fact, deviating from the benchmark to find truly sustainable companies can fuel outperformance. That’s because companies selling sustainable products and employing sustainable business practices can create meaningful competitive advantages. Forward-looking, ESG-focused companies can benefit from strong long-term growth potential, improved profitability and reduced risk. By contrast, market-cap-weighted benchmarks often emphasize declining legacy technologies.

ESG-focused investing strategies are coming under greater scrutiny. Investors should always make sure that they understand how a fund is investing their assets. But don’t dismiss tech-sector holdings in sustainable funds. Technology stocks are a vital component of the modern global economy and an important agent for positive change that have a natural home in ESG-focused portfolios.

Dan Roarty is Chief Investment Officer—Thematic and Sustainable Equities at AB.

Related: Are High-Yield Returns Predictable? Key Metric Suggests Yes