How a Top-Performing ESG Fund Invests in Energy Stocks

Over the past three years, the $1 billion fund has produced a 11.7% annualized return, besting 95% of funds in Morningstar’s Global Large-Stock Blend category, which averaged only 7.7%. Even better, Vanguard Global ESG (ticker: VEIGX) has shown consistent outperformance, beating over 80% of its peers in each full calendar year since launching in June 2019. That includes 2022’s terrible bear market, when only oil stocks really did well. That year, it fell 10%, while the
S&P 500 index
fell 18% and its average peer fund dropped 17%. The global MSCI ACWI ESG Leaders index lost even more—20%.

How do Vanguard Global ESG’s co-managers—Mark Mandel and Yolanda Courtines—do it? For one, they don’t look at ESG criteria in isolation, but as part of each company’s overall structure, which includes growth and valuation criteria. Unlike Vanguard’s index funds, the fund is actively managed by subadvisor Wellington Management, which runs over $1 trillion. It also helps that the fund’s 0.57% expense ratio is lower than most of its active-fund competitors.

Wellington has a better rating than Vanguard from Morningstar on ESG issues. It also remains a member of Net Zero Asset Managers Initiative, a global commitment by financial firms to have zero carbon emissions by 2050, which Vanguard pulled out of last December.

Wellington provides Mandel and Courtines with 52 traditional global industry analysts plus another 11 just focused on ESG. The end result is a concentrated portfolio of just 35 to 45 global companies “with high returns on capital that have strong balance sheets and cash flow,” Courtines says. The duo look for evidence of what she calls ESG “stewardship” that helps create an economic moat around the business and a unique brand to insulates it from competitors. The moat “is supported by strong stakeholder relations, including great relationships with your workforce, your customers, and your supply chain,” she says.

Though concentrated funds tend to be volatile, the quality and stewardship emphasis here reduces volatility, as companies in the portfolio tend to be more economically resilient.

Mandel and Courtines also try to keep the fund diversified sector-wise, enabling it to perform well when different sectors shine. “A lot of ESG funds have a growth stock bias because they tend to be overweight consumer and tech stocks and underweight cyclical industries like energy,” Mandel says. “We have a broad representation of stocks across regions and sectors. We don’t own energy names directly, but we own utilities that are good proxies for the energy transition that we’re going to undergo for the next 20 years.”

The fund holds utilities like Britain’s
National Grid
(NG.UK) and Spain’s
Iberdrola
(IBE.Spain) that can pass along rising energy costs to their customers, so they held up better during last year’s inflationary environment than tech stocks did. Yet they are also part of the green-energy solution to climate change, Iberdrola being the world’s largest wind power producer.

“Capital allocation is a tremendous challenge for [traditional oil-and-gas companies] because they are starting to pivot to adapt to the energy transition” to renewable energy, says Courtines. “But there’s risks of financial stranding and physical stranding of [oil and gas] assets for them.” She worries that while a lot of money is chasing renewables like wind, fossil-fuel companies are late to the game and won’t be able to generate similar returns on their capital as they have in the past.

Since updating and increasing the capacity of electric grids is essential for replacing gasoline-powered cars with electric vehicles, Courtines is “really excited” about National Grid’s prospects. “We don’t think of utilities as growth stocks,” she says. “But I think there’s a growth stock element that hasn’t been there in many years.” The company is helping to connect wind farms to Britain’s grid and building EV-charging stations. The stock is also attractively valued, with a 13 price/earnings ratio and a 4.7% dividend yield.

Another company that prospered in last year’s inflationary environment was farm equipment manufacturer
Deere
(DE). Mandel says Deere’s earnings have almost tripled since the pre-Covid era, in part due to inflationary price increases in food and tractors but also due to a new CEO’s cost-cutting. What interests Mandel especially, though, is how the company has integrated environmental stewardship into its business to increase profitability.

“Deere’s including more technology in their tractors,” Mandel says. “Most high-end tractors today now have a [Global Positioning System]…which can track where each seed is planted when the farmer goes out to plant the field. On future passes for the tractor when farmers are spraying pesticides, the tractor can now spray each individual seed rather than spraying the whole field. You end up saving 75% on pesticide use. So, you save the farmer money, the farmer is more productive, and it’s good for the environment.” Deere can also charge more for such high-tech tractors—a win-win for everyone.

Part of being a good corporate steward is thinking long term for every stakeholder—investors, customers, employees, and the environment. Mandel and Courtines want companies with executives who think in years instead of quarters. Similarly, they invest long term, having a typical expected holding period for stocks of 10 years. You won’t find many recent purchases or sales in this fund.

Still, 2022’s volatility presented buying opportunities. In May, the fund invested in French cosmetics company
L’Oréal
(OR.France) as it sold off. Courtines likes its use of sustainable, safe ingredients. But most important is the dominance of L’Oréal’s brand. “You talk to peers, and they say, we can’t even go in the hair-care space because L’Oréal has such a lock on it,” she says.

The fund also purchased Dutch semiconductor equipment maker
ASML Holding
(ASML) in October because of its leadership in equipment to manufacture high-end chips as well as its efficient use of water—a problem area for semiconductors.

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