Climate change investing 101: How I finally wised up and dropped fossil fuels from my IRAs

[Please read the disclaimers.]

Lately, the chorus of climate activists and climate scientists admonishing people and institutions to divest from fossil fuels has been growing louder. Some institutions, like the University of California system, have responded. The UC provides an interesting reasoning: Divestment is not in response to public pressure about climate change, it’s because fossil fuels are a bad investment–and I’m filling in between the lines here–due to their role in climate change. Perhaps the UC is signaling to all that it’s safe to go ahead and divest from fossil fuel companies. Nonetheless, for small, self-managed investors, it’s not altogether obvious how to get out of fossil fuel investments through a giant broker like Vanguard while maintaining a diversified and financially sound portfolio. 

I have no idea how many individual investors–people like you and me– have personally divested from fossil fuels. One article that I came across claims that 25% of assets under management (AUM) worldwide are in funds that screen companies for Environmental, Social, and Governance (ESG) criteria before committing to investing in those companies, and more recent articles and analyses suggest that this fraction is increasing. However, ESG investment trends are not all that useful for tracking fossil fuel divestment because an ESG-screened fund does not necessarily equal a fossil-fuel-free fund.

Only a couple of years ago, articles in the mainstream media, like this one in the New York Times, cast fossil fuel divestment as a feel-good move for wealthy tree huggers who could afford to lose a few bucks. Although the article provides some helpful leads for identifying low-carbon funds, it doesn’t grasp the urgency of mitigating unchecked climate change through decarbonization of the economy. Nor did it foresee, as I will illustrate below, that if investors had dropped fossil fuels at the time the article was published, the move would likely have been financially rewarding. There’s been some acknowledgement of climate change and investment risk from large financial companies like BlackRock. BlackRock has promised to set up some fossil-free mutual funds and ETFs. I hope that there will be substantive offerings with more than just virtuous names. While awareness of climate risks and the role of fossil fuel divestment in mitigating those risks seems to growing in the financial industry, personal finance articles, like this gem in the New York Times, continue to be climate ignorant, urging young investors to put money into broad-based index funds without thinking about where the money is going. Not only is the money going to the bad actors whose activities are threatening the futures of young investors, it will more likely than not earn a poorer return compared with investments in fossil-free, carbon-efficient alternatives. Since the media fails to connect the dots on climate change, fossil fuel companies, and personal finance, I am going to do some dot connecting in this post, while offering a practical overview of some fossil-free investment options that are available to the average investor.

In the remainder of this post, I will:

In forthcoming posts, if you subscribe to my free mailing list, I will: 

• Walk you through the nuts and bolts of how I divested at Vanguard and invested in renewables.
• Perform a similar analysis of divesting at TIAA-CREF.
• Alert you when I update this and other posts
• Keep you updated when I publish a book.

part 1: Comparing large stock mutual funds and ETFs with and without the fossil fuel majors 

Let’s start with the big behemoth of index fund investing, the Vanguard Total Stock Market Index (VTSMX or VTSAX). It returned 31% in 2019. It has almost $900. billion in assets as of early February 2020. Great fund, right? You can own shares of the whole stock market with a few clicks. Set the investment on autopilot and forget it. The laziness of investing in an index fund like this is one of the reasons that I’ve stayed in it. I’m now embarrassed that I held this fund for so long. To make up for it, I am sharing my divestment research with you.

According to Vanguard’s own disclosures, 4.1% of the fund is invested in Oil & Gas. No big deal, right? That’s probably what I was thinking when I originally bought this fund. No big deal. The fund is dominated by Big Tech: Microsoft, Apple, Alphabet, Amazon, and Facebook. Big Tech is simply a bigger player in today’s economy than Big Oil.  But the fossil fuel exposure is deeper than it appears at first. The wonderful website, fossilfreefunds.org, estimates that 8.25% of VTSAX is invested in fossil fuels. This includes the majors (ExxonMobil, Chevron, ConocoPhillips), the minors (Valero, Occidental), as well as fossil-powered utilities like Dominion and Black Hills, and oilfield service companies like Schulumburger. In the aggregate, VTSMX/VTSAX has over $8 billion invested in Exxon, making it the largest shareholder of Exxon in the world. Vanguard’s and other companies’ mutual funds combined account for about a third of the ownership of Exxon. As an institution, Vanguard is Exxon’s largest shareholder, and the largest mutual fund owner of fossil fuels. The University of California’s claimed divestment of $150 million is a paltry sum compared with Vanguard’s $319 billion of fossil fuel investments. 

Exxon has invested millions (or more?) in climate denial propaganda despite their own scientists knowing the climate risks of their fossil fuel products since the late 1970s or early 1980s. Exxon continues to procure fossil fuel reserves and fossil fuel infrastructure. The more of these reserves that are recovered and burned, the more warming there will be and the worse things will get.

That said, from a purely selfish personal finance perspective, is having Exxon-Mobil and similar stocks in your portfolio good for your investment, even if they’re only a small fraction of a very large mutual fund?

To address this question, I am going to compare VTSMX with funds that are similarly large and diverse but have reduced exposure to fossil fuel companies.

First, let’s compare VTSMX with ESGV, an ETF that Vanguard has offered since September 2018. ESGV screens out the oil majors, but still leaves some enablers like Schulumberger, Valero, and Phillips 66 (in other words: oilfield service companies, refiners, and retailers are still in the fund). The fossil fuel screen is narrowly defined – it only weeds out the companies that own “proved or provable reserves in coal, oil, or gas.” In any case, ESGV’s fossil fuel exposure is only 2.38% (this number and all subsequent fossil fuel estimates come from fossilfreefunds.org). Like VTSAX, ESGV’s largest holdings are in Big Tech.

For as long as they’ve both been around, which is only about 15 months, ESGV has beaten VTSMX by four percentage points. 

Maybe I shouldn’t compare a traditional mutual fund with an ETF.  Here’s the fossil-fuel-laden ETF (VTI) vs the ETF without Big Fossil (ESGV):

ESGV is in blue; VTI is in red.  The two timeseries are highly correlated. But ESGV is a clear winner, at least for 2019 and early 2020.

I can’t argue, based on 15 month’s worth of data, that a (mostly) fossil-free fund like ESGV is better for long-term investing. As a climate scientist who has spent his career interpreting climate data, I know that a trend cannot be discerned from a year’s worth of data.

Another important caveat is that there are subtle differences in the way that ESGV and VTI or VTSMX weight the individual holdings. Whereas ESGV is explicitly market-cap weighted, the methodology for VTI and VTSMX is less clear. As of the end of December 2019, the top 10 holdings in ESGV comprised 23.8% of total net assets, whereas they comprised 19.9% of net assets in VTSMX. The top four holdings in each fund looked like this:

Top holdings in major ETFs and index funds at Vanguard as of December 31, 2019. Source: Vanguard.com

One could argue that heavier weight to the top four holdings in ESGV — Apple, Microsoft, Alphabet and Amazon — has juiced the performance of the fund relative to VTSAX. Big Tech stocks–which were on a tear during this time period– may have played an out-sized role in ESGV’s performance. (Some analysts classify Alphabet as communications and Amazon as consumer discretionary. For the purposes of this article, I’m calling all of them Big Tech.)

To further explore the weighting argument, we can compare ESGV with Vanguard’s S&P 500 index, VFIAX. As seen in the table above, the top holdings are similarly weighted in ESGV and VFIAX.

ESGV beats the S&P 500 index fund, but only by about 2.5 points, compared with 4 points in the earlier match up.

I have also ignored to this point the fact that the fossil fuel screen is but one of nine screens employed for ESGV. Other screens include tobacco, alcohol, weapons, and gambling. I’m a scientist, and I recognize that so far I’m not describing a controlled experiment that isolates the impacts of fossil fuel divestment. I would guess that on the basis of market cap, the fossil fuel screen is more powerful than the other screens. (For more details, see the description of the FTSE US All Cap Choice Index, the index that ESGV is designed to track.)

Other major brokerages were quicker to the fossil-free divestment game than was Vanguard, and they provide funds with and without fossil fuels that are more comparable in their weighting methodology. The fund SPYX has a single, narrowly defined screen, that according to State Street, allows “climate change-conscious investors to align the core of their investment strategy with their values by eliminating companies that own fossil fuel reserves from the S&P 500.” Let’s look at two S&P 500 ETF’s offered by State Street, SPY (the normal one) and SPYX (the one without fossil fuel reserves):

This graph above begins in late 2015. SPY (red) and SPYX (blue) were neck and neck until about May 2017, when SPYX started pulling away. The divergence accelerated during 2019. SPYX gained about 3% more than SPY over the past 4 years. Although free of fossil fuel reserves, SPYX is no environmental saint. It has 6.2% fossil fuel exposure and a number of unsavory holdings. Still, the trend of the somewhat fossil-free fund outperforming its Big Fossil counterpart is discernible. SPYX tends to weight each of the top sectors about 0.5% to 1% more than SPY; it’s less tilted towards technology than Vanguard’s ESGV fund.

The bottom line is that purging the stocks of Big Oil from a flagship S&P 500 index fund hasn’t hurt the fund’s performance.

Let’s change our mindset now and try a 0% fossil fuel fund. We want something big and diversified that could form the foundation of a portfolio. One that is broader than a single-sector play like a cleantech ETF, a Big Tech ETF, or a Real Estate ETF. Those funds are too volatile. I’ve found a good candidate: ETHO, the US Climate Leadership ETF.  ETHO has unique selection criteria that go well beyond the typical ESG screens. It scans sector by sector, identifying the companies with the lowest carbon footprint, including their supply chains, operations, and disposal & recycling. It weights its individual holdings equally rather than by market cap. Due to its unique weighting methodology and its exclusions of “sin” industries besides the fossil fuel industry, ETHO doesn’t really provide for a controlled experiment on the impact of fossil fuel divestment. Still, it provides further evidence that fossil fuel holdings are not necessary for strong performance.

Since 2016, ETHO (in red), has been crushing our old friend VTSMX, 72% to 55% as of the time of writing. I wish I had heard of ETHO sooner. I like ETHO’s portfolio. Unlike ESGV or SPYX, ETHO isn’t heavy in Big Tech, Big Banks, Big Pharma, or Big Anything. In a broad sense, ETHO is sector-weighted similarly to ESGV. Both have approximately 25% in tech stocks and an even spread of 15-20% each in Financials, Health Care, and Consumer Goods. This broad diversification explains why the ETHO time series is well correlated VTSMX or ESGV. It’s unlikely to do something weird relative to the market on the whole – except maybe grow at a faster pace than it’s cousins with Big Fossil holdings. In the case of ETHO, it is hard to argue that Big Tech stocks (Microsoft, Alphabet, and Facebook aren’t even holdings; Apple and Amazon are) have significantly pulled the fund up relative to the market average. The selling point of ETHO, besides its strong historical performance, is that each dollar invested in the fund generates 50%-80% less CO₂ emissions than a dollar invested in conventional index funds like Vanguard’s VFIAX (S&P 500) or VTSAX (total stock market). As you will see in the final section of this article, this claim is backed up by data from fossilfreefunds.org (I do not know if the data sources are independent.). The investment thesis behind ETHO is that carbon-efficient companies have operational efficiencies that translate into competitive advantages in the marketplace, enabling them to outperform companies that are major carbon polluters.

part 2: Renewable energy and cleantech stocks have been absolutely crushing their fossil fuel counterparts during the fossil-fuel-hugging Administration.

The above analysis suggests that large, diversified stock mutual funds without the fossil fuel majors are doing better than the traditional funds with the fossil fuel majors. However, the fossil-free or somewhat fossil-free funds funds that I’ve mentioned aren’t necessarily strongly invested in renewable energy or cleantech. To drive the energy transition and address climate change, we need to proactively invest in clean energy and cleantech and not just defensively divest from fossil fuels. 

If you search the internet, you will find a stream of articles touting the likes of PBW, TAN, FAN, SMOG, ICLN, ACES, and PBD. A full listing is here. To make a long story short, the fund I like right now is called QCLN. Consistent with my arguments above, QCLN has a 0% fossil fuel rating from fossilfreefunds.org. It is not just a solar or wind energy fund; it also invests in lesser-known renewables like hydrogen as well as technology like semiconductors, digital displays, and batteries. The holdings include notable renewable energy stocks like Tesla, Brookfield Renewable Partners, and NextEra Energy Partners. Another fund I’m watching is PBW, which has similar holdings but they’re equally weighted, so the fund isn’t as jolted by the dramatic movements of single stocks like Tesla.

The performance of QCLN has been looking stellar for the past year or so:

QCLN (in blue) has gained about 37% compared with 20% for VTSAX (in red). That’s nice. But don’t we still “need” fossil fuels? How has Big Fossil been doing all by itself?  With the guidance of fossilfreefunds.org, I identified one of the most carbon-intensive funds available. FENY’s fossil fuel score is 99.5%. It’s a market-cap weighted fund, just like the S&P 500 index funds or ESGV that I have discussed above. Almost 45% of the fund’s assets consists of Exxon, Chevron, and ConocoPhillips stocks. FENY provides a useful index for tracking the progress of Big Fossil. It’s not looking pretty:

In the graph above, QCLN is in blue and FENY is in red. Since late 2013, FENY has lost about 40% of it’s value. In the meantime, QCLN has gained over 55%. 

It’s safe to say that fossil fuel stocks have been a real drag on the market. Even CNBC talking head Jim Cramer has said it. From a purely selfish personal finance perspective, I think it’s a dumb dumb idea to have fossil fuel stocks in my long-term portfolio. I am not even factoring in the escalating economic and social costs of unmitigated climate change. 

Some people will say, “But the dividends! Big Fossil pays dividends!” They will be reminded of Big Fossil’s dividends the next time a hurricane, flood, or wildfire–made worse by Big Fossil’s CO₂ emissions–threatens their house.

part 3: Putting it together: Investing with a lower carbon footprint, less fossil fuel industry exposure, and better return in mind

To summarize, I have compiled data into two tables, which display the funds discussed in this article and their carbon footprint and fossil fuel industry exposure data from fossilfreefunds.org.

According to fossilfreefunds.org, the carbon footprint estimates the carbon emissions that are generated per unit of investment. It is measured in metric tonnes of CO₂ or CO₂ equivalents per $1 million USD invested.

The fossil fuel industry exposure measures the percentage of the fund’s total assets that are invested in fossil fuel stocks. Fossil fuel stocks include the top 200 owners of carbon reserves, coal companies, oil and gas companies, coal-fired utilities and gas-fired utilities. 

Broad-based market index funds, focused on US companies, with their carbon footprint and fossil fuel industry exposure.

Sector-based or growth-oriented mutual funds and ETFs, focused on US companies, with their carbon footprint and fossil fuel industry exposure.

What does the data mean?

For every $10. invested in an S&P 500 index fund, about $0.92 goes to the fossil fuel industry. For every $10. invested in ESGV, $0.24 goes to the fossil fuel industry.  For every $10. invested in ETHO, $0.00 goes to the fossil fuel industry. Switching from VINX/VOO to ESGV within a portfolio would be about a 74% percent reduction in the money invested in the fossil fuel industry, and slice the carbon footprint of the investment by almost half.

The fossil fuel numbers refer to direct investment in fossil fuel industry stocks. They do not account for say, the money that Amazon spends on gasoline and diesel fuel to ship packages. The carbon impact of those activities, I presume, is reflected in the carbon footprint ratings.

What about returns?

Using data and plotting tools from Morningstar.com, I plotted the performance of the low, medium, and high carbon broad-based funds over the past four years (the length of time that ETHO has been around). The chart shows the change of a $10K investment in each of the funds. Returns factor in expense ratios but may not include the costs of transacting shares of the fund, reinvested dividends, tax implications, etc.

As the chart shows, the hypothetical $10K invested in ETHO would have netted $7031. while VTI lags behind, netting below $5392. SPYX is in the middle of the pack at $6100. With dividends factored in using Morningstar’s data, ETHO gets about a 5% boost, returning $7571. The higher dividends of VTI help it narrow the gap, boosting the return to $6723. Over a decade or more, this gap might be closed, but then again it might not. Between SPY and SPYX, the difference in SEC yield is not large at 1.52% and 1.69% respectively, suggesting that dividend payments are not a good excuse for staying invested in Big Oil through index funds.

Workplace retirement plans may not allow the trading of ETFs. They do often include very inexpensive index funds like VINIX (which is THE most popular 401(k) mutual fund). In the next chart, VINIX is compared with mutual funds VTSAX and TIAA’s low carbon offering, TNWCX (TNWCX has a respectable carbon footprint compared to conventional broad-market funds but it has a high proportion of its assets invested in oil and gas companies and utilities). TNWCX is most comparable with VTSAX and VRTTX, a tracker of the Russell 3000 index. In this matchup of $10K invested in each of the funds using the same dates as above, VINIX returns $6974., TNWCX $6872., VTSAX $6714. and VRTTX $6668. Once again, the fund without the Big Oil stocks beats the funds that have them. Not shown here is a new contender from Vanguard, the FTSE Social Index, VFTAX, which behaves more like a cleaned up S&P 500 index (the dirty version of the S&P 500 is XLE). It’s current fossil fuel and carbon footprint numbers place it in the middle of the pack, but these rankings should improve when the fund implements a comprehensive fossil fuel screen in March 2020.

A handful of independent investment companies have marketed sustainable mutual funds for decades. The largest of these funds by AUM is the $18 billion Parnassus Core Equity fund, PRBLX. An actively managed large-cap fund, PRBLX has slightly under-performed the benchmark S&P 500 over the past few years, returning only $6531. in the example above. While always managed with sustainability in mind, PRBLX was only declared fossil fuel free in 2019. The aces up PRBLX’s sleeve are 1) Its longevity and 2) Its lack of reliance on Big Tech holdings. In addition, the managers of PRBLX like to talk about their goal of preserving the fund’s value during market downturns. Taking the long view, the following graph compares PRBLX with VINIX and TRBCX, the growth fund discussed in the next section, for the period July 1, 1993 to February 7, 2020.

Overall, PRBLX (in dark blue) comes out in the middle, returning $134,110. for our hypothetical wise investor of $10K in 1993, compared with $169,133. for TRBCX (green) and $115,850. for VINIX (red). In this story of the turtle and the hares, the turtle (PRBLX) barely experienced the tech bubble of the late 1990s and early 2000s, and it has lagged the hares (VINIX and especially TRBCX) in the Big Tech surge of the past four years. In the market crash of 2008, PRBLX lost 23% for the year, compared with losses of 43% for TRBCX and 37% for VINIX. The starting point matters. If the hypothetical investment were made just a couple of years later, in 1995, PRBLX would have tied TRBCX. If it started in the middle of the tech bubble, PRBLX would be beating TRBCX by about $20K today, and if it had started in the 2009 recession, TRBCX would be beating PRBLX by about $15K today. PRBLX has a track record of avoiding bubbles and beating the market over the long haul. Before reading the next section, it may be worth reading a cautionary tale about going all-in on Big Tech.

Low carbon and high tech: A winning combination?

The matchups between traditional index funds and their non fossil fuel counterparts suggest two drivers of the superior performance of the latter: (1) The absence of fossil fuel stocks, which have been a drag on the market and (2) The increased presence of technology stocks, which have propelled the market to record highs. Large-cap US growth funds tend to be low carbon and heavily invested in Big Tech. A good example is Invesco’s QQQ, which tracks the Nasdaq 100 Index. With a carbon footprint of 25 and fossil fuel score of 0.89%, QQQ has outperformed ETHO and the S&P 500 and total stock market index trackers. Firms like Apple and Microsoft, which top QQQ, can generate a lot of revenue per dollar invested without burning much carbon. Interestingly, QQQ has no financial stocks like JPMorgan Chase. For some, fleeing from big banks (which finance fossil fuel infrastructure) is an important part of divestment. Funds like QQQ aren’t marketed as sustainable or ESG, but by carbon footprint and fossil fuel metrics, they are quite good. In addition, companies like Amazon and Microsoft have the wealth and the scale to invest in renewable energy themselves, helping the entire renewable energy industry in the process. A popular option in retirement plans, the actively managed T Rowe Price Blue Chip Growth Fund (TRBCX), has performed about as well as QQQ, has good carbon and fossil fuel metrics, and is well regarded by ratings firms. The lack of fossil fuel holdings in this fund is a tacit acknowledgement that fossil fuel stocks are not growth stocks.

Two caveats about investing in renewable energy ETFs

First, it bears repeating that single-sector ETFs like QCLN aren’t designed to be a big part of an IRA or 401(k). Second, since QCLN is a small fund and it’s invested in small manufacturers, the carbon footprint of the fund per unit invested is higher than the per-unit footprints of VTSAX and other broad-market index funds. If investing in a fund like QCLN, you are betting that the companies in the fund will contribute to securing lower-carbon energy for all sectors of the economy. Of the several clean energy and cleantech ETFs that I’ve mentioned in this article, QCLN has the lowest carbon footprint according to fossilfuelfunds.org.

Other contenders

In the final inning of writing this post, I came across the Change Finance US Large Cap Fossil Free ETF, CHGX. It uses a brute-force method to drop fossil fuel companies from an initial list of the 1000 largest US companies. Unlike ETHO, CHGX does not specifically select for companies with low carbon footprints. Whereas ETHO is a smooth blend of holdings from large, medium and small companies, CHGX is invested in the largest companies within each of the non-energy sectors. For me, it’s hard to envision where CHGX would slot into a portfolio. There are going to be many funds marketed as the investment solution to climate change; each one will need to be examined closely to see if it meets your needs.

Climate Risk and Opportunity

An entire climate-related investing topic that I have only alluded to in passing is climate risk, which considers the vulnerability of a company’s or fund’s assets to things like sea level rise and extreme weather. Firms such as FourTwentySeven and a few others are addressing this, but thus far seem to be catering to corporate and government investors more than personal investors. For personal investors, it seems likely that companies such as Vanguard will offer more index funds based on sustainable and climate-adjusted indices developed by companies like FTSE Russell. Such indices are intended to capture the upside of the transition the green economy, in addition to avoiding the downside risks.

Climate change poses systemic risks to the financial system. Grading individual stocks, bonds, and mutual funds for fossil fuel exposure and/or climate risks can only go so far to provide comfort to investors. In my opinion, mitigation (reducing CO₂ emissions) is the most important aspect of reducing long-term climate risk, and divestment from fossil fuels and investment in renewable energy is one strategy to contribute to mitigation.

Conclusion

I hope you have found this article useful and that it inspires positive action. If so, please share it with your social networks. Consider getting in touch with a climate scientist like this one or giving them a follow on Twitter.

In forthcoming posts, if you subscribe to my free mailing list, I will: 

• Walk you through the nuts and bolts of how I divested at Vanguard and invested in renewables.
• Perform a similar analysis of divesting at TIAA-CREF.
• Alert you when I update this and other posts
• Keep you updated when I publish a book.

Important sources:

Fossil Free Funds, https://fossilfreefunds.org/

Vanguard, https://investor.vanguard.com/home

Etho Capital, https://ethocapital.com/

FTSE Russell, https://www.ftserussell.com

ETF.com

morningstar.com

The Forum for Sustainable and Responsible Investment

Disclaimers

Disclaimers: When it comes to personal finance and investing, I am just a regular guy and a self-directed investor. I am not a financial advisor or wealth manager nor do I employ one. I do not understand all of the nuances of investing. Nothing in this article should be considered as investment advice or recommendations to buy or sell specific products. Past performance is not a guide to future results. Do your own research or consult with a financial advisor before making major investment decisions. I have written this article on my personal time and posted it to this website, which is maintained at my own expense. I have not received any compensation for writing this article from any of the brokerages, funds, ETFs, companies, websites, or stocks discussed here. I am a climate professional who is concerned about climate change and ending the fossil fuel era while accelerating the transition to clean energy. The opinions expressed in this article are mine alone, offered in my capacity as an informed private citizen; they are not associated with any of my past or present employers or research funders. This article reflects publicly available data obtained in late January and early February 2020; it may or may not reflect market conditions when you read it.