Building on the environmental, social and governance awareness (ESG), "sustainability" and "sustainable investing" are some of the latest buzzwords to permeate the exchange-traded funds (ETFs) industry. The realm of ESG and sustainable ETFs, which can also be deemed socially responsible investing (SRI), is growing rapidly in terms of population. When liberally applying ESG and sustainability definitions, the universe of such ETFs is close to 70, and that includes a growing number of fixed-income funds.

Important

The U.S. Department of Labor released a new regulation in late October 2020 that may limit or eliminate socially responsible investing in retirement plans. While the rule was revised to remove explicit references to environmental, social, and governance (ESG) factors, it mandates that fiduciaries of retirement plans choose investment strategies based entirely on how those strategies affect financial performance. This ruling may have a significant impact on funds and investments classified under ESG and socially responsible investing.

As determined by Bloomberg, by January 2018, the number of US funds espousing virtuous and sustainable investing—including mutual funds and ETFs—was around 206. ETFs are still a small part of the SRI equation, with many of the largest sustainable ETFs hovering around the neighborhood of $15 billion in assets.

One major socially conscious ETF is the iShares MSCi KLD 400 Social ETF (DSI). DSI tracks the MSCI KLD 400 Social Index. "The MSCI KLD 400 Social Index is designed to provide exposure to companies with high MSCI ESG Ratings while excluding companies whose products may have negative social or environmental impacts," according to MSCI. "It consists of 400 companies selected from the MSCI USA IMI Index, which includes large, mid, and small-cap U.S. companies. It aims to select companies with the highest ESG Ratings in each sector and maintain sector weights similar to those of the parent index."

An important factor investors should consider with DSI, or any sustainable fund for that matter, is that these products' stories are equally about what is excluded from the funds as what is included. Regarding DSI, the ETF's underlying index excludes stocks from some predictable industries, including alcohol, firearms, gambling, nuclear power, pornography, and tobacco.

Even with all those exclusions, DSI is home to 403 stocks, and even when accounting for the various industries it will not hold, DSI does provide exposure to all 11 GICS sectors. Not surprisingly, the energy, materials, and utilities sectors are three of the ETF's five smallest sector weights, combing for just under 15% of the fund's portfolio.

Conversely, the technology sector is usually a hallmark of sustainable funds, and DSI is no exception. DSI devotes 32.39% of its weight to technology stocks, a substantial overweight to that sector relative to the S&P 500. Six of the ETF's top 10 holdings are technology stocks, including Microsoft Corp. (MSFT) and Google parent Alphabet Inc. (GOOG).

Over the past three years, DSI has slightly trailed the S&P 500, but there are times when the ETF does beat the U.S. equity benchmark. DSI's three-year standard deviation of 10.64% is only slightly above the 10.04% found on the S&P 500, but the sustainable ETF sports a lower dividend yield and a modestly higher price-to-earnings ratio.