In recent years, interest in environmental, social, and governance (ESG) investing has surged. More investors are seeking ways to align their portfolios with their personal values, whether that’s avoiding fossil fuels, steering clear of weapons manufacturers, or backing companies with stronger corporate governance practices. At the same time, low-cost index funds have remained the cornerstone of many portfolios, offering broad, diversified exposure at minimal cost.
This has created a natural point of comparison: ESG-screened exchange-traded funds (ETFs) versus traditional, or “vanilla,” index funds. Both products often track similar markets – such as the ASX200 or MSCI World – but they take different approaches to selecting the companies included. Understanding the trade-offs between them can help investors decide which option aligns best with their priorities, without assuming one is universally better than the other.
What are ESG-screened ETFs?
An ESG-screened ETF is an exchange-traded fund that applies filters to its holdings based on environmental, social, and governance factors. The idea is to exclude or tilt away from companies that fail certain sustainability or ethical criteria.
Here's how screening works:
- Exclusions: Many ESG ETFs start by excluding industries considered harmful or controversial. Common examples include tobacco, fossil fuels, gambling, weapons, and thermal coal.
- Positive screening: Some funds go further, actively weighting towards companies with stronger ESG scores, such as those with better carbon disclosure practices or more diverse boards.
The challenge is that ESG criteria are not standardised. One provider may exclude fossil fuel producers entirely, while another may allow companies that generate less than a set percentage of revenue from fossil fuels. Others might focus heavily on governance and corporate behaviour rather than environmental impact.
Key point: ESG ETFs are not all the same. Investors need to look closely at the index methodology to understand what a fund does and doesn’t include.
What are vanilla index funds?
Vanilla index funds represent the traditional model of passive investing. These funds aim to replicate the performance of a broad market index without applying additional filters.
Characteristics include:
- Broad exposure: Funds like ASX200 ETFs, S&P500 trackers, or MSCI World ETFs are designed to capture the performance of large segments of the market.
- No ESG screen: They include all companies in the index, regardless of their industry or practices.
- Diversification and cost focus: These funds are generally among the cheapest and most liquid options, with long track records.
In short, vanilla index funds prioritise maximum diversification and low cost, without filtering out companies based on ethical or sustainability concerns.
Key differences between ESG-screened ETFs and vanilla index funds
While both products may track similar geographies or markets, the details can diverge significantly.
1. Holdings
The most obvious difference lies in what’s excluded. For example, an ESG-screened global equities ETF may avoid fossil fuel producers like ExxonMobil or BHP, while a vanilla global fund includes them. This can alter the fund’s sector balance and top holdings list.
2. Performance
Because ESG ETFs exclude certain companies, their performance can drift from the parent index. Sometimes this leads to outperformance – for example, during periods when fossil fuel stocks are under pressure – and sometimes underperformance, such as when energy companies rally. Over longer periods, the performance gap tends to be modest, but can still compound.
3. Fees
ESG ETFs often come with slightly higher management fees. For example, a broad vanilla global equities ETF might have a management fee of 0.18% per year, whereas an ESG-screened version of the same index might charge 0.25–0.30%. The difference may look small, but it can add up over decades.
4. Diversification
Vanilla funds include every company in the index, providing exposure to all sectors of the economy. ESG-screened funds may tilt away from entire industries, such as energy or defence. This can increase exposure to other sectors like technology or healthcare.
5. Size and liquidity
Vanilla index funds tend to be larger and more liquid, simply because they’ve been around longer and serve as the default option for many investors. ESG ETFs, being newer, are often smaller, which can affect bid–ask spreads and trading costs.
How to compare them side by side
If you’re evaluating an ESG ETF against a vanilla equivalent, here are some key points to check:
1. Index methodology
Look at how the ESG screen is applied. Is it based on exclusions, positive tilts, or both? Which industries or revenue thresholds are targeted? This will give you insight into how “strict” the screening is.
2. Top holdings
Compare the top 10 holdings of both funds. Often you’ll find overlap (e.g., Apple, Microsoft, Commonwealth Bank), but the weightings may differ. If key companies are missing, ask why.
3. Sector weights
Review the sector allocations. For instance, does the ESG ETF underweight energy and overweight tech? Does it tilt towards financials or healthcare? This helps you understand where your exposure shifts.
4. Historical performance
Check how the ESG fund has performed against its vanilla counterpart over different time horizons. Keep in mind that past performance isn’t a predictor of future results, but it can highlight how exclusions have affected returns in different market environments.
5. Fees and management costs
Look at the management expense ratio (MER) or ongoing costs. Even a difference of 0.10% per year can compound over a long investment period.
6. Fund size and liquidity
Larger funds tend to have lower bid–ask spreads and more reliable tracking. Smaller ESG funds may still be growing, which can sometimes influence trading costs.
Broader considerations
Beyond the numbers, there are bigger-picture factors that often shape investors’ choices:
Values alignment
For many, ESG ETFs are attractive because they better align with personal ethics. Choosing not to invest in industries like fossil fuels or tobacco can be as much about values as about financial outcomes.
Diversification vs purity
The stricter the ESG screen, the more concentrated the fund may become. This raises the trade-off between achieving strong alignment with values and maintaining broad diversification.
Risk of greenwashing
Because ESG criteria are not standardised, funds can market themselves as sustainable while applying minimal or inconsistent screening. Investors need to check the methodology to avoid assuming “ESG” always means the same thing.
Regulatory trends
Governments and regulators are paying increasing attention to ESG disclosure and labelling. Over time, rules may tighten, leading to more transparency and potentially more consistency across ESG products.
Conclusion
ESG-screened ETFs and vanilla index funds both offer investors simple, low-maintenance ways to access markets. The difference comes down to how companies are selected. Vanilla funds include everything in the index, with the aim of maximising diversification and minimising cost. ESG funds apply filters to reflect sustainability or ethical considerations, which can alter holdings, sector weights, fees, and performance.
For those comparing the two, the key is to look closely at index methodology, holdings, fees, and fund size – while also considering broader factors like values alignment and greenwashing risks. As is so often the case in investing, there’s no universal “better” option. The choice depends on what matters most to each investor: lowest cost, broadest exposure, or closer alignment with personal ethics.
