Investors should examine the underlying holdings of their ESG-focused funds to determine hidden portfolio risk.

CNBC’s Mitch Goldberg warns that a lot of the outperformance in many ESG funds has nothing to do with ESG factors. Instead, the credit for the ESG outperformance should go to the sizable component of technology stocks in these funds’ portfolios.

Technology stocks have significantly outperformed the broad market and maybe the hidden booster to your ESG fund’s performance.

Sector Funds (example technology) Masquerading as ESG?

Goldberg cites the example of the Vanguard ESG U.S. Stock ETF, which is up a solid 28% year-to-date. That’s much better than the S&P 500 ETF return of over 25%, resulting in a more than 2% outperformance. But analyze the fund’s holdings list, and you’ll find that it holds a 28% sector to technology. This is much higher than in the S&P 500 ETF’s 20% holding and explains the difference in performance.

On the flip side, lower exposure to technology explains underperformance; for example, in the iShares MSCI USA ESG Select Social Index Fund. This fund has trailed the S&P500 by 35% over the past decade. The clue: It does not hold Amazon.

How hidden portfolio holdings could increase your risk

Imagine that you have an exposure to technology through a pure technology ETF. But you might have effectively increased your exposure (and risk) to the sector by investing in an ESG fund, which, unknown to you had 28% in technology. Taken together, your risk of a meltdown in the tech sector has grown more than you intended.

“Since technology has been a market leader, it makes sense that ETFs that are overweight tech stocks — meaning they have a higher percentage of holdings in tech than the S&P 500 index does — would beat the index,” says Goldberg.

“My basic point is that the more investors migrate to customized indexes rather than the primary core market indexes, the more they need to look under the hood at holdings,” he adds.

The objective is to avoid duplicating exposure through various funds, and also to remove any emotional quotient (‘feel-good’) to the investment decision.

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