Sustainable Bottom Line: Focused sustainable funds employing a “core/ESG light” strategy make it possible to achieve broad market exposure, low tracking error, and market-based returns.
Selected focused sustainable large blend funds can be integrated into conventional portfolios without materially altering a portfolio’s risk–return profile
For investors and financial intermediaries effectively positioned with conventional diversified portfolios consisting of mutual funds and ETFs but with a desire or directive to gain some level of exposure to sustainable investments, one approach is to incorporate such investments into the core equity holdings of a portfolio without materially altering a portfolio’s risk–return profile. A suitable entry point is to introduce a large blend sustainable investing option into a portfolio’s equivalent allocation as this focused sustainable investing category offers a robust range of large blend active and passively managed mutual funds and ETFs, including a number of highly rated funds that employ a “core/ESG light” strategy that makes it possible to maintain the hallmarks of traditional index-based investing: broad market exposure, low tracking error, and market-based returns. For a listing of focused sustainable large blend mutual funds and ETFs, click on the tab that appears at the end of the article. That said, investors may have to accept some compromises around their sustainability preferences by limiting the environmental, social, and governance (ESG) adjustments restrictions placed on sustainable portfolios.
A definition of sustainable investing
In the U.S., there is no single formal definition, regulatory or otherwise, of “sustainable investing” that all firms use. However, among practitioners, a widely accepted definition refers to sustainable investing as an investment approach that considers environmental, social and governance (ESG) factors alongside financial returns in investment decision making, with the intention to achieve long-term value. Investment approaches vary widely but can be broadly classified into seven categories. These include values-based investing, ESG screening or exclusionary strategies, thematic investing, impact investing, ESG integration and shareholder advocacy, issuer engagement and proxy voting. The enumerated strategies are not mutually exclusive. Moreover, differences exist in the adaptation of these approaches. For example, funds that employ ESG screening and exclusions and, in some cases combined with an ESG integration approach, can be stratified into two broad sub-categories comprised of core/ESG light strategies and more active/tilted strategies. Depending on the approach, investors can achieve a range of financial returns, from market-rate returns to below market-rate returns. Refer to the Glossary/Definitions section for a more detailed definition of sustainable investing.
Understanding core/ESG light strategies
As between core/ESG light strategies and more active/tilted approaches, funds pursuing a core/ESG light approach are designed to mirror the broad U.S. equity market (often represented by the S&P 500, MSCI USA Index or FTSE Social Index) while applying limited environmental, social, and governance (ESG) adjustments or restrictions. Unlike some values-based, thematic or impact-oriented approaches that consist of funds seeking high alignment with social or environmental outcomes, core/ESG light strategies retain the fundamental structure of traditional large blend portfolios while introducing modest sustainability tilts or exclusions. Funds in this category are predictably index tracking funds. Their methodologies fall into one of four sub-categories:
a) Screening-based approaches. These approaches, which are employed by funds such as the Vanguard ESG U.S. Stock ETF or Vanguard FTSE Social Index Fund, exclude companies involved in activities that many investors wish to avoid (e.g., tobacco, controversial weapons, fossil fuels, adult entertainment, or gambling) while keeping capitalization weights intact.
b) Optimization or “ESG Leaders” approaches. These approaches, exemplified by funds such as the iShares ESG MSCI USA Leaders ETF, Xtrackers MSCI USA Selection Equity ETF, or Fidelity U.S. Sustainability Index Fund, reweight portfolio constituents toward higher-rated ESG peers within each sector, maintaining sector neutrality and minimal tracking error.
c) Hybrid or “Screened + Scored” approaches. These approaches characterize funds such as the SPDR S&P 500 ESG ETF and Xtrackers S&P 500 Scored & Screened ET. They combine baseline exclusions with ESG scoring to omit the lowest-scoring companies but otherwise preserve the sector composition and factor exposure of the S&P 500 Index.
d) Stewardship-only/Proxy voting approach. This approach, which applies only to the TCW Transform 500 ETF, involves complete replication of the underlying index while seeking to encourage best practices in corporate governance through the application of its proxy voting guidelines and engaging in a dialogue with management of the portfolio companies.
Each of these designs supports investors seeking to introduce sustainability characteristics incrementally, without sacrificing diversification or risk efficiency.
Why these funds fit into conventional portfolios
The principal appeal of core/ESG light strategies lies in their low tracking error relative to conventional or standard market indexes. Because the underlying universes and weighting schemes closely resemble those of conventional benchmarks, these funds generally exhibit limited performance deviations versus their non-ESG counterparts. Wider tracking error deviations, on the other hand, may be experienced by portfolios that shift beyond some limited range of screening, exclusions and weighting schemes that deviate from conventional benchmarks. This allows investors, financial intermediaries and asset allocators to integrate them into model portfolios or separately managed accounts with minimal disruption to existing allocation frameworks, capital-market assumptions, or client performance expectations.
That said, it should be noted that the very largest conventional cap weighted index tracking funds exhibit tracking errors that are essentially zero or very close to zero. For example, the Vanguard S&P 500 ETF, the Vanguard S&P 500 EFT and the Fidelity 500 Index, the three largest conventional index funds, operate with a tracking error of 0.11%, 0.00% and 0.01%, respectively. On the other hand, large blend funds employing core/ESG light strategies exhibit low to medium tracking errors starting as low as two basis points (TCW Transform 500 ETF) and as high as 2.5% (iShares ESG MSCI KLD 400 ETF). That is still a modest tracking error, but an order of magnitude higher than the plain vanilla trackers, attributable largely to the implementation of screening and tilts rather than implementation slippage.
Beyond close tracking, these core/ESG light strategies offer a familiar investment experience, passive, transparent, and low cost. Their expense ratios are often within a few basis points of traditional index ETFs, reflecting the scalability of ESG data integration and optimization models. For many advisors, this removes a historical barrier to entry: sustainability can now be incorporated without operational complexity or higher fees.
Refer to the table below that displays the most highly rated (A rated) large blend mutual funds and ETFs that employ a core/ESG light strategy.
Practical Integration Options
For conventional investors with established large-blend core holdings, there at least two practical integration paths. The first involves a partial substitution approach in which a portion (e.g. 5% or 10% or 20%, to mention a few allocation options) of a core index position, such as an S&P 500 Index or total-market index, is replaced with a sustainable counterpart like ESGV or SUSL. This maintains the portfolio’s beta exposure while implementing a commitment to ESG integration. The second approach is to introduce a dedicated sustainable sleeve alongside existing conventional holdings. This may include multiple ESG-light funds diversified by index provider or methodology to mitigate provider-specific biases. In either case, investors can gradually migrate from conventional to sustainable benchmarks as confidence and client comfort grow, ensuring return patterns remain comparable during the transition.
Each approach enables investors to test and scale ESG integration in a measured, data-driven fashion.
Broader Considerations
Incorporating core/ESG light large-blend strategies also carries strategic benefits beyond alignment with investor values. Many of these indexes explicitly avoid firms with high controversy or regulatory risk exposure, potentially lowering headline risk while marginally improving portfolio resilience. Moreover, the continued expansion of sustainable index data sets enhances transparency and reporting capabilities for advisors seeking to meet client disclosure expectations or evolving fiduciary standards.
It is important, however, to distinguish between modest ESG alignment, impact investing, thematic investing and some values-based investing approaches. ESG-light funds do not typically target measurable environmental or social outcomes; rather, they represent a pragmatic bridge, a first step toward sustainability integration that preserves the economic and risk characteristics of conventional core equity investments.
Conclusion
For mainstream investors and intermediaries, focused sustainable large blend funds provide a seamless entry point into responsible investing. By substituting or complementing traditional index exposures with ESG-screened or optimized alternatives, portfolios can reflect emerging sustainability considerations while maintaining market-based returns and efficient diversification. In this way, core/ESG light strategies allow investors to evolve their portfolios—not revolutionize them—aligning long-term investment discipline with modern expectations of corporate responsibility and fiduciary stewardship.
Glossary/Definitions
Core/ESG-Light strategy. Broad-market, low-tracking-error strategies applying light ESG screens or optimization while preserving benchmark exposures.
SRA Fund Quality Rating. Fund quality ratings are assigned to funds within their designated investment category/segment. Ratings combine qualitative as well as quantitative considerations and are derived based on an assessment of five fundamental factors. These are: (a) Management company. A fund should be offered and managed by an established firm with a positive reputation, to ensure effective fund operations and impart trust and confidence in the organization. (b) Years in operation. The fund should be in operation for at least three years and managed pursuant to the same investment strategy or approach—to provide a sufficiently long but not excessively long view against which to evaluate the fund’s operations, strategy, and performance. Some exceptions may apply. (c) Fund size. The fund’s total net assets should generally exceed around $30 million—so that it may be managed more efficiently and provide some protection against the fund’s early liquidation or closure. Some exceptions may apply, particularly in the case of funds offered by larger, established firms. (d) Total returns. The fund’s performance results, achieved by adhering to a relatively consistent investment strategy and sustainability approach, are evaluated relative to an appropriate securities market index over a one year, three year and five-year intervals, and (e) Expense ratios. A fund’s expense ratio is evaluated relative to other funds in the same investment category/segment.
Factors d and e above are evaluated and scored quantitatively, based on a fund’s investment results over the trailing one-, three- and five-year time intervals relative to a designated benchmark as well as a fund’s expense ratio relative to its investment category/segment. Once scored, factors a, b and c are considered, and funds may be excluded from the rated funds universe based on these considerations. Fund quality ratings are then assigned to all remaining funds based on the following distribution: Top 15%=A, next 20%=B, next 30%=C, next 20%=D and final 15%=E.
NR indicates that a rating has not been assigned to the fund due to its use of leverage or the fund’s exclusion due to the consideration of factors a, b or c, for example, fund size.
High-Conviction ESG Leaders. Index or active strategies selecting top-tier ESG performers, usually with tighter concentration.
Stewardship-Only. Strategies that seek to encourage best practices in corporate governance through the application of its proxy voting guidelines and engage in a dialogue with management of the portfolio companies while seeking to replicate the performance results of a conventional index.
Sustainable investing. In the U.S., there is no single formal definition, regulatory or otherwise of “sustainable investing” that all firms use. However, among practitioners, a widely accepted definition refers to sustainable investing as an investment approach that considers environmental, social and governance (ESG) factors alongside financial returns in investment decision making with the intention to achieve long-term value. Investment approaches can vary widely and include: (a) Values-based investing. Also referred to as faith-based investing, socially responsible investing, responsible investing, ethical investing or investing based on a set of morals, the guiding principle is that investments are based on a set of beliefs with a view to achieving a positive societal outcome. Typically, this approach is implemented via negative ESG screening or exclusions. (b) ESG screening or exclusionary strategies. This involves an emphasis on positive or negative scoring pursuant to which stocks or bonds may be overweighted or underweighted in portfolios based on their ESG scores or excluded in their entirety. In such cases, companies or certain sectors or industries are excluded as eligible securities from portfolios based on specific ethical, religious, social or environmental guidelines or preferences. Traditional examples of exclusionary strategies cover the avoidance of any investments in companies that are fully or partially engaged in gambling and sex related activities, the production or manufacturing of alcohol, tobacco or firearms, or even atomic energy. These exclusionary categories have been extended in recent years to incorporate additional considerations, for example, firms that are the subject of serious labor-related actions or penalties by regulatory agencies or demonstrate a pattern of employing forced, compulsory or child labor, or firms that exhibit a pattern and practice of human rights violations or are directly complicit in human rights violations committed by governments or security forces, including those that are under US or international sanctions for grave human rights abuses, such as genocide and forced labor. Closely related is the strategy of divestiture or divestment. (c) Impact investing. Still a relatively small but growing slice of the sustainable investing segment, impact investments are incremental (additional) moneys directed to companies, organizations, and funds with the intention to achieve measurable social and environmental impacts alongside a financial return. Impact investments can be implemented in both emerging and developed markets and made across asset classes, such as equities, fixed income, venture capital, and private equity. In each instance, the objective is to direct capital to address challenges in sectors such as sustainable agriculture, renewable energy, conservation, microfinance, and affordable and accessible basic services, including housing, healthcare, and education. Historically, impact investments have targeted a range of returns from below market to market rate, depending on the investors’ strategic goals. But increasingly, impact investing strategies are expected to at least achieve risk-adjusted market rates of return. (d) Thematic investing. An investment approach with a focus on a particular idea or unifying concept, for example securities or funds that invest in solar energy, wind energy, clean energy, clean tech and even gender diversity, to mention just a few of the leading sustainable investing fund themes. Investing in low carbon emitting stocks and bonds or green bonds or funds also fall into the thematic investing category. (e) ESG integration. This is a widely practiced investment strategy by which environmental, social and governance factors and risks are systematically analyzed and, when these are deemed relevant and financially material to an entity’s performance, they will influence decisions on whether to buy or hold a security, and to what extent. Such considerations may lead to the liquidation of security from the portfolio but at the same time, these factors may also identify investment opportunities. (f) Shareholder advocacy, issuer engagement and proxy voting. These strategies, which leverage the power of stock ownership in publicly listed companies and, regarding engagement, the power of bond investments, are action-oriented approaches that rely on learning about each company’s ESG practices and related risks and opportunities. These strategies may also extend to influencing corporate behavior through direct corporate engagement, filing shareholder proposals and proxy voting.
Tracking error. Tracking error is the measure of how closely a fund’s performance tracks its benchmark index, calculated as the standard deviation of the difference between the fund’s and the index’s returns. In simpler terms, it shows the variability of the performance gap between the fund and its benchmark, indicating the extent to which a fund deviates from its target index. For example, a fund aiming to replicate the S&P 500 will have a low tracking error if its returns closely match the S&P 500 Index, but a high one if its returns fluctuate significantly more or less than the index.
