A fund with "ESG" or "sustainable" in its name sounds like it does one specific thing. It does not. The label covers three different strategies that can end up holding almost nothing in common, and the company ratings underneath them disagree with each other far more than most people assume. Here is what each version actually does, and how to check what a fund owns instead of trusting the name.
The Three Strategies the Label Covers
Exclusion screening starts with an ordinary index and deletes things. The rule is usually a revenue threshold, often 5%: drop any company that earns more than 5% of its revenue from thermal coal, tobacco, or weapons. Everything else stays. The fund still looks a lot like the index it was carved out of.
Best-in-class scoring keeps every industry and ranks companies inside it. A rating agency scores each company against its own peers, and the fund holds the top of each group. No industry is deleted, because the goal is to reward the better operator within each one.
Impact and thematic funds skip the ranking and buy a narrow set of companies doing one thing, such as building solar equipment or treating water. These are sector funds wearing a values label, with the concentration risk the types of ETFs article describes.
Why Two ESG Funds Can Hold Opposite Things
Take one oil and gas producer and run it through all three. The exclusion fund drops it, because the rule looks at what business it is in. The best-in-class fund may hold it, and may even grade it highly, because it is being compared with other oil producers rather than with a software company. The thematic fund never considered it and owns a solar manufacturer instead.
None of the three is broken. They answer different questions. The first asks whether an industry belongs in your portfolio at all. The second asks which company inside an industry handles its risks better than its rivals. The third asks who sells the solution.
That is why you cannot read a fund's holdings from its name. Two funds on the same shelf, both called sustainable, can overlap very little.
The Ratings Underneath Them Disagree
Best-in-class funds run on scores bought from ESG rating agencies, and those agencies do not agree with each other. Florian Berg, Julian Kolbel and Roberto Rigobon studied six of the major providers in a paper called "Aggregate Confusion," published in the Review of Finance in 2022. The correlations between pairs of agencies ran from 0.38 to 0.71. A correlation of 1.0 means two raters agree completely, and 0 means one score tells you nothing about the other. The big credit rating agencies, grading the same bonds, agree at correlations above 0.9.
The paper splits the disagreement into three causes. Measurement is 56% of it, meaning the agencies look at the same issue and reach different conclusions about the same company. Scope is 38%: they do not measure the same list of issues to begin with. Weight is the last 6%, where they agree on the facts and rank their importance differently. The authors also found a rater effect, where an agency that scores a company well overall tends to score it well in every category.
The practical result is that a company's ESG grade depends partly on who is grading. A fund built on one provider's data can hold a company another provider treats as a laggard.
What the Prospectus Actually Commits the Fund To
Greenwashing is the gap between what a fund's marketing suggests and what its rules require. The name is not a rule. Neither is the wind farm on the fact sheet. The rules sit in the prospectus, under the heading "Principal Investment Strategies," and the verbs there tell you most of what you need.
"The fund will exclude issuers deriving more than 5% of revenue from thermal coal" is a commitment. Anyone can test it against the holdings. "The adviser considers ESG factors alongside other factors" commits to nothing, because considering something and then buying it anyway is permitted.
Read the threshold, not just the theme. A 5% revenue screen keeps a large conglomerate whose coal division happens to be 4% of sales. Check whether the screen measures revenue or production, and whether it is applied once at purchase or tested continuously.
The Sector Tilt You Get for Free
Screening out fossil fuel producers, mining and heavy industry does not leave you a smaller copy of the market. It leaves a portfolio tilted toward technology, healthcare and consumer companies, which is roughly the tilt a growth fund has.
That tilt explains a large share of ESG fund performance in both directions. In 2020, technology rallied while energy fell, and screened funds beat the broad market. In 2022 the order reversed: energy was the strongest sector by a wide margin and technology dropped hard, and the same funds trailed. Very little of either gap was about ESG. It was a sector bet riding inside the screen.
So a two year return tells you almost nothing about whether the screening approach works, and a values based fund moving differently from its parent index is the design working, not a malfunction.
How to Check What a Fund Holds
US ETFs post their complete portfolio on their website every business day. SEC Rule 6c-11 requires it, so market makers can price the shares against the real basket, which means none of this has to be taken on faith.
Four documents answer the question:
The daily holdings file. Pick three companies you would refuse to own and search the list for them by name.
The sector weights, next to the plain index version of the same market. That is where the tilt shows up.
The index methodology, published as a PDF by whoever built the index. It names the screens, the thresholds, and which rating agency supplies the scores.
The prospectus, for the strategy language above.
Cost belongs in the check as well. Screened funds usually charge more than the plain index fund they are built from, and the article on how to choose ETFs covers what a gap in expense ratio does to a balance over time.
Matching a Fund to Your Own Line
No published screen matches anyone's values exactly. It cannot, because it has to be a rule that runs across thousands of companies without a person judging each one. So the question worth asking is narrower: does the rule this fund publishes overlap with the line you would draw yourself?
Write down what you will not own before you start shopping. Then open the holdings file and search for it. If it is in there, the fund does not do what you wanted, whatever the name on the front says.
