This article first appeared on and analyses the US mutual fund industry. It has been edited for an Australian audience.

When BlackRock chief executive Larry Fink unveiled his new vision for sustainability as the "new standard for investing," he charted an ambitious course for his firm and investors in its funds, and threw down the gauntlet to BlackRock's competitors.

In the process, Fink both highlighted and tackled head on the hurdles that environmental, social, and governance (ESG) investing needs to overcome in order to make it into a mainstream investment strategy with broad acceptance among investors and the financial-services industry. These are also challenges that BlackRock itself must show it can meet.

Underlying Fink's argument is that sustainability in the form of climate change is a real risk throughout the global economic landscape, and as a result, investors should incorporate this risk into investment decisions and portfolio construction.

This notion of ESG as an investment risk happens to also be at the heart of the updated Morningstar Sustainability Rating language. The sustainability rating is now based on assessments made by our partner, Sustainalytics, as to individual companies managing the ESG risks particular to their industry and business.

Fink's belief that fund companies and investors have a role to play in managing and alleviating the climate risks we face means that sustainable investing has to be more than just "greenwashing," that is, using ESG as an asset-gathering and marketing ploy. A true ESG mandate comes with a set of responsibilities that requires fund companies to relinquish their traditional posture of neutral middlemen.

Here are four main takeaways from Fink's letter:

More ESG portfolio building blocks

American investors have been flooding money into broad-based indexes, and target-date funds (multi-asset funds where the asset mix shifts dynamically, becoming less risky over a person's working career and into retirement) have become the primary mode of retirement investing for most individual investors. For ESG investing to become more widespread, it will need to ride those waves, not fight them.

As Morningstar's director of sustainability research Jon Hale noted, flows into U.S. sustainable funds surged in 2019 to a new record of $20 billion. But there is a long way to go: $20 billion is a drop in the mutual fund industry bucket. (On its own, Vanguard Total Stock Market Index (VTSMX) took in nearly $19 billion in 2019.)

Part of the problem is that there aren't many ESG investment options that would pass a basic investment screen. Out of 288 U.S. funds identified as ESG-focused by Hale, only 155 have track records of more than three years and assets of more than $50 million. Some categories of U.S. stock funds have only a handful of ESG funds that would pass this screen: Small-cap value has just one.

What could change this? Of course, time will lengthen track records of new funds. But the overall number of investment choices remains slim.


In terms of BlackRock's ESG lineup, Fink only addressed this from a global perspective, saying the firm would double the number of exchange-traded funds and index funds to 150. He didn't specify what that meant for the U.S. lineup, but out of iShares' current ETF lineup of roughly 370 funds, 14 are ESG strategies. (Most of these were added in the past few years.)

In addition, Fink said BlackRock would develop a sustainable LifePath target-date strategy and work to build adoption of ESG strategies among retirement plans.

Saving the world shouldn't cost more

As we have written on many occasions, the dramatic shift among investors toward index strategies isn't just a story about the kinds of funds they invest in, it's how much they cost. Investors are not just moving to lower-cost funds, but to the cheapest of the cheap.

ESG investing was traditionally the domain of smaller, specialised asset managers, and their higher fees reflected that niche aspect of the group. That left investors facing a question: How much more am I willing to pay to save the earth?

This has begun to change in recent years. Take U.S. intermediate core bond funds. There are only nine ESG funds in this category, but since 2017, three lower-cost index funds have been launched. That includes Fidelity Sustainability Bond Index (FNDSX) and iShares ESG U.S. Aggregate Bond ETF (EAGG), both with expenses of roughly 10 basis points. That's still double the net expense ratio of iShares Core U.S. Aggregate Bond ETF (AGG) but well below the average 64 basis points for the category.


But there remain more opportunities to make ESG investing more competitive. In many fund categories, there's a scarcity of low-cost ESG funds. For example, there isn't a single ESG index-based intermediate core-plus bond fund; the only options in that Morningstar Category are actively managed funds with an average expense ratio 3 times that of non-ESG core-plus index funds. Meanwhile, there are just three large-growth ESG index funds, the cheapest of which is 3 times more expensive than Vanguard Russell 1000 Growth ETF (VONG).

Or take world large stock fund category. Morningstar counts 22 actively managed ESG funds in this category, but their average expense ratio of 132 basis points is 22 basis points higher than the non-ESG offerings in the category (of which there are dozens).


Of course, it's not a surprise that a fund with an added layer to the investment process--in this case an ESG screen--will cost more than a market-cap-weighted index. But how much additional cost is really required? Narrowing these expense ratio gaps will be crucial to ESG's acceptance.

A stronger voice from funds

There are few levers that funds can pull in order to have an impact on the companies whose stocks they hold: They can lobby management, vote in corporate elections (proxy voting), or sell the stock. Index funds are locked into holding stocks contained in the index they are tracking.

Here, BlackRock's track record will take some improving. As we noted in our look at proxy voting on S&P 500 index funds in 2019, out of 72 proxy ballot questions addressing social and environmental concerns from companies in the index, BlackRock supported only five.
If there is one place that funds have real leverage, it's with their votes to elect members of corporate boards.

Jackie Cook, who follows proxy voting issues at Morningstar, notes that BlackRock's proxy voting guidelines for directors are already more specific than most of the mutual fund industry. Its policy states, "For companies in sectors that are significantly exposed to climate-related risk, we expect the whole board to have demonstrable fluency in how climate risk affects the business and how management approaches assessing, adapting to, and mitigating that risk."

More broadly, Fink now says BlackRock "will be increasingly disposed" to vote against managements that haven't made enough progress on sustainability issues. He also took a step that Cook says would propel the firm into a leadership position on proxy voting disclosure, announcing that BlackRock will start reporting proxy votes on a quarterly basis, and on certain high-profile votes, it will immediately disclose its votes along with an explanation.

Cook lists several ways for BlackRock and other fund companies to have a real impact on the sustainability front: They need consistent votes in support of issues, to vote down directors showing poor oversight of environmental and sustainable issues, and to vote down so-called say-on-pay resolutions where sustainability metrics aren't part of the determination.

Fund companies can also announce ahead of time how they will vote on high-profile questions, Cook notes. Other means include sponsoring strategically placed shareholder resolutions and publicly opposing the SEC's efforts to curtail shareholders' rights to file shareholder resolutions.

Actively considering ESG

If the standard for what passes as sustainable investing is still coming into focus, integrating ESG considerations into a firm's overall investment strategy is still very murky. As Hale has written, there has been a jump in the number of U.S. funds inserting language into their fund prospectuses declaring that they will now consider ESG factors in security selection. Fink listed several ways in which ESG will be folded into BlackRock's active investment process.

How this plays out at BlackRock and for any other fund companies following in its footsteps will only become clear over time. This includes the logistics of how exactly a large, established firm like BlackRock fully integrates ESG into all of its existing strategies. Dan Culloton, the director of equity strategies for Morningstar manager research, raises the question of how firms do so without impeding existing strategies or changing their nature by making them more centralised because of the ESG factor inclusion.

For example, if energy stocks reverse years of underperformance, or high-carbon-producing names become market leaders, will managers let their funds' relative performance suffer in the name of ESG consideration?

One measure to watch will be the sustainability ratings on BlackRock's actively managed funds for signs of improvement. Out of the 78 active funds that receive sustainability scores, nine receive the highest rating of 5 globes, and 20 have above-average ratings with 4 globes.


For active managers broadly, it may be that they see ESG as a new opportunity to deliver alpha, especially in parts of the stock market where they have had a harder time differentiating themselves, such as large-cap stocks.

For investors, however, this creates some confusion and uncertainty. When ESG is just one factor in a fund's process, investors can't rely on that fund profile remaining the same.
Morningstar's own metrics are evolving as well to factor in the explosion of "ESG consideration" funds, which aren't offered as ESG products but incorporate ESG considerations into their investment strategies. Starting Jan. 31, Morningstar's labeling of a fund as an ESG fund will be limited to those strategies that employ ESG as a core part of their process.

Add it all up, and Fink has charted an ambitious path for ESG investing to become accessible and accepted. The next step would be for BlackRock and other firms to follow through on taking that path.