Why ESG Investing Might Be Costing You Money (And What to Do About It)

Vanguard's ESG U.S. Stock ETF (ESG) returned 18.1% in 2023, while the S&P 500 gained 24.2%. That 6.1% difference might not sound huge, but on a $50,000 investment, you left $3,050 on the table.

This performance gap isn't a fluke. Environmental, Social, and Governance (ESG) investing has captured $2.3 trillion in assets, but the data tells a different story than the marketing materials.

The ESG Performance Problem

Let's be honest about what the numbers show. Over the past five years, most ESG funds have underperformed their traditional counterparts.

The iShares MSCI ACWI ESG Leaders ETF (SUSL) has delivered an annualized return of 8.9% since 2019, compared to 11.2% for the iShares MSCI ACWI ETF (ACWI). That's not a small difference when compounded over time.

Why? ESG funds often exclude entire sectors that have performed well. Most ESG funds won't touch oil companies like ExxonMobil or Chevron, even when energy stocks were the best performers in 2022. They also tend to overweight technology and healthcare stocks, creating concentration risk.

The Expense Ratio Drag

ESG funds charge more because they require additional research and screening. The average ESG fund charges 0.63% annually, compared to 0.44% for traditional index funds.

On a $100,000 portfolio, that's an extra $190 per year. Over 30 years, assuming 7% returns, this seemingly small difference costs you approximately $18,500 in lost wealth.

The Greenwashing Reality

Here's the part fund companies don't advertise: many ESG funds still hold companies you might not expect.

The Vanguard ESG U.S. Stock ETF's top holdings include Apple (which has faced criticism over labor practices in China), Microsoft, and Amazon (not exactly known for worker-friendly policies). Meanwhile, it excludes Tesla – arguably the most impactful environmental company of the past decade – because of Elon Musk's governance issues.

This creates a paradox where ESG funds might exclude companies making genuine environmental impact while including others with questionable practices simply because they check certain governance boxes.

A Smarter Approach to Values-Based Investing

You don't have to choose between making money and aligning with your values. Here are three strategies that work better than broad ESG funds:

Strategy 1: Direct Stock Selection

Buy individual stocks of companies making real impact. Instead of paying 0.6% for an ESG fund that might hold questionable companies, build a focused portfolio.

Consider companies like:

• Brookfield Renewable Partners (BEP) - pure-play renewable energy
• NextEra Energy (NEE) - largest wind and solar generator in North America
• Johnson & Johnson (JNJ) - healthcare innovation with strong governance
• Patagonia (private, but you can invest in outdoor companies like VF Corporation that own similar brands)

This requires more research, but you'll know exactly what you own.

Strategy 2: The 90/10 Split

Put 90% of your money in low-cost index funds like the Vanguard Total Stock Market ETF (VTI) with a 0.03% expense ratio. Use the remaining 10% for targeted investments in specific ESG themes.

This approach gets you market returns on most of your money while still expressing your values. The performance drag from the 10% ESG allocation won't kill your overall returns.

Strategy 3: Impact Investing with Real Assets

Skip public markets entirely for your values-based allocation. Invest in:

• Solar installations on your own property (typical ROI: 6-10% annually)
• Community development financial institutions (CDFIs)
• Real estate investment trusts (REITs) focused on affordable housing
• Direct lending to small businesses through platforms like Kiva

These investments often provide better returns than ESG funds while creating measurable impact.

The Surprising Winners

Some of the best-performing stocks over the past decade don't score well on traditional ESG metrics, but they've created enormous shareholder value.

Netflix transformed entertainment consumption, reducing the environmental impact of physical media. Amazon revolutionized logistics efficiency. Even controversial companies like Philip Morris International have invested billions in smoke-free alternatives.

The lesson? Real-world impact doesn't always align with ESG scoring methodologies.

What About Your 401(k)?

Most employer retirement plans now offer ESG options, but they're usually expensive actively managed funds. If your 401(k) ESG options charge more than 0.5% annually, you're better off choosing low-cost index funds and doing your ESG investing in taxable accounts where you have better options.

Many people forget that you can express your values through shareholder voting too. Own broad market funds, then vote your proxy shares on environmental and social issues. Most brokers make this easy through online platforms.

The Math That Matters

Let's run the numbers on a 30-year investment timeline. Assume you're investing $10,000 annually:

• Traditional index fund (0.04% fee, 10% return): $1,809,434
• ESG fund (0.63% fee, 9.4% return): $1,479,297
• Difference: $330,137

That's a significant amount of money to give up, especially if the ESG fund isn't delivering the impact you expect.

Making ESG Work for You

Don't abandon values-based investing entirely. Just be smarter about it.

Start with low-cost core holdings that will drive most of your wealth building. Then add targeted investments that align with your specific values rather than broad ESG funds that might not represent what you actually care about.

The most impactful thing you can do might not involve ESG funds at all – it might be building enough wealth to donate meaningfully to causes you support while your investments compound at market rates.