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Vanguard Gets It Mostly Right With Actively Managed ESG Fund

Jon Hale, Ph.D., CFA (jon.hale@morningstar.com)

I thought Vanguard missed the mark with the two environmental, social, and governance exchange-traded funds it launched last September. That's because Vanguard ESG U.S. Stock ETF  ESGV and Vanguard ESG International Stock ETF  VSGX focus on exclusionary screening rather than on positive ESG integration.

The typical passive ESG fund tracks an index that is constructed using company-level ESG analytics to tilt its portfolio toward companies that are doing a better job addressing the material ESG risks and opportunities facing their businesses. The Vanguard ETFs, however, don't reflect an ESG integration approach. They are throwbacks, evoking the pre-ESG era when "socially responsible" portfolios employed a more limited negative-screening approach that excluded companies based on their products or practices.

I was pleasantly surprised, however, to read Vanguard's announcement of its latest foray into sustainable investing with its recent filing for Vanguard Global ESG Select Stock. This will be an actively managed offering subadvised by Wellington Management, which manages the $100 billion  Vanguard Wellington  VWELX and runs more than $350 billion in various mandates for Vanguard.

The new fund will focus on 40 or so companies that Wellington believes "demonstrate exemplary long-standing ESG practices and have strong business fundamentals and management teams with proven track records of good capital-allocation decisions for shareholders." The fund expects to hold stocks over "an extended time horizon, resulting in low portfolio turnover."

Importantly, the plan is for Wellington to be an active owner, as well: "In addition to investment advisory responsibilities, Wellington Management will be responsible for governance activities for the fund. This will enable the fund managers to fully integrate proxy voting and company engagements into the fund's investment strategy."

I like the promise of active ownership and the idea of a compact portfolio of long-term holdings. Too many active managers water down their portfolios with weak-conviction stocks. That tendency can especially work against ESG portfolios, which often end up looking not all that different from conventional ones. A low-turnover portfolio of high-conviction stocks of companies that are committed to sustainability is likely to resonate with sustainable investors.

While its ESG work has been largely under the radar, Wellington is a top-quality manager that can be expected to implement ESG in a thoughtful way. It has already integrated ESG analysis firmwide. In addition, Wellington subadvises two sustainable funds for Hartford, its other longtime fund partner: Hartford Global Impact HGXAX and Hartford Environmental Opportunities HEOMX . Neither fund focuses on ESG integration quite like the new offering will, but both are in the vicinity with their emphases on impact and environmental opportunities.

Some Caveats
It's worth noting that Wellington was not successful as a longtime subadvisor to Domini Impact Equity DSEFX , a relationship that ended last year. But that involved its quant team trying to implement an optimized version of what used to be the Domini Social Index, so that experience appears to have little bearing on the new Vanguard fund.

Mark Mandel and Yolanda Courtines will comanage the fund, and while the two have years of portfolio-management experience, this appears to be their first serious dive into ESG investing.

I also have a quibble with the fund's global-equity focus. Global-equity funds can be hard to fit into the typical asset allocation used by U.S. investors, which has separate allocations to U.S. equity and non-U.S. equity. That makes it more straightforward to use U.S.-focused strategies to fill a U.S. equity allocation and non-U.S. strategies for a non-U.S. equity allocation. Moreover, U.S. investors already have 25 ESG integration or impact funds from which to choose that are in the world large-stock Morningstar Category.

But, because we're talking about Vanguard, these caveats are not likely to stop investors from flocking to the new fund, which will also be cheaper than virtually all of its actively managed peers, whether ESG-focused or not. The Admiral shares will have an expense ratio of 0.45%, and the Investor shares 0.55%. The average expense ratio in the world large-cap stock category for institutional share classes, which are generally the cheapest type, is 0.88%.

Those "throwback" Vanguard ETFs each have around $250 million in assets after only six months. Of course, they're passive funds, but with all this new offering has going for it out of the gate--low fees, a quality subadvisor, and a well-conceived approach to ESG--I expect successful asset-gathering, for sure. We'll see if Mandel and Courtines can execute successfully once the fund launches midyear.