Engine No. 1’s New ETF (VOTE) Brings ESG Activism to Index Investors

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A tiny fund shop is trying to disrupt some of the biggest trends in investing today: It is bringing an activist approach to sustainable investing, and doing it via an exchange-traded fund. That’s no easy task, but the early results are promising.

Last month, Engine No. 1, an asset management firm with $240 million in assets founded just last year, took everyone by surprise when it won three board seats at oil giant Exxon Mobil (ticker: XOM) after a six-month proxy fight. The firm’s small size and short history were only part of the reason for the surprise. Engine No. 1, which at that point was just a hedge fund, owned just 0.02% of Exxon’s shares. The company says Exxon needs to reduce its carbon emissions significantly and move toward cleaner energy.

Now, Engine No. 1 wants to bring that kind of activism to a wider audience. The firm recently launched the

Engine No. 1 Transform 500

ETF (VOTE), which tracks a

Morningstar

index that is very similar to the

S&P 500

and carries a low expense ratio of 0.05%. At first glance, it may look like just another large-cap index fund.

What makes the Engine No. 1 ETF unique is its explicit mandate to use the shares it owns to propose, advocate, and vote for environmental, social, and corporate governance, or ESG, changes.

For decades, ESG investing has focused on owning companies that have a positive impact on sustainable issues, or divest from those that don’t meet such criteria. Mutual funds and ETFs don’t have great track records when it comes to ESG-related proxy voting, and rarely bring measures up themselves. Large passive asset managers such as Vanguard,

BlackRock

(BLK), and

State Street

(STT) vote least often in favor of ESG resolutions. These fund behemoths often claim they engage with companies through meetings and more nuanced conversations.

But it’s hard for outsiders to gauge how effective that is, says Jackie Cook, director of sustainability stewardship research at Morningstar: “The [funds] don’t identify what companies they are talking with, what issues they are addressing, and which companies have made what changes in response to the engagement.” BlackRock, Vanguard, and State Street declined to comment.

Engine No. 1’s mission is “a more aggressive theory of change than any fund has taken,” says Cook, who has researched ESG activism for more than two decades. Still, with just $133 million in assets, the new ETF is too small to make a difference entirely by itself. It needs to get other, bigger players on board, as it did with the Exxon proxy contest. BlackRock, Vanguard, and State Street all publicly voiced their support and voted with Engine No. 1. “Our Exxon campaign is the best example of how a small ownership could have quite a big impact based on the investors you bring along with you,” says Yasmin Dahya Bilger, Engine No. 1’s ETF lead.

The fund industry has become more vocal on ESG matters. In BlackRock’s annual letter to shareholders in 2020, the ETF giant made sustainability its “new standard for investing.” State Street says it intends to use its vote to “hold boards and management accountable.”

Even Vanguard, which lags behind peers in ESG products and assets, is beefing up its expertise in the area. Many fund companies have begun disclosing their proxy voting every quarter, versus the required annual notification, and those results suggest increasing support for ESG-related resolutions. “Asset managers are differentiating themselves based on their ESG activities,” says Cook. “Engine No. 1’s victory on Exxon is accelerating a trend already on the way.”

Investors’ increasing interest in ESG is a major reason behind this shift. “Retail investors can make a lot of noise on Reddit, but they haven’t had any real impact on the companies because they are so dispersed,” says Wei Jiang, finance professor at Columbia Business School. An ESG-activism driven fund, like Engine No. 1’s new ETF, could provide a platform for retail investors to express their voice and aggregate that dispersed power, she says. “A passive investor can still be a very active shareholder.”

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Broad-market index funds that embrace ESG initiatives could have widespread appeal, says Cook: “Investors can choose funds based on their proxy voting history, which will become the differentiator [among funds] that are really interchangeable otherwise.”

Coming off the Exxon campaign, Engine No. 1 looks well positioned to spearhead this movement; it has notched a well-known success and has ESG as its sole focus. Many larger asset managers, on the other hand, will inevitably face many more restrictions, as they have to consider other business relationships with the companies they invest in, says Jiang.

Of course, there are challenges. If the new ETF’s assets don’t grow fast enough, Engine No. 1 might have limited capital to support costly activism campaigns and proxy contests. The firm would also have to continue proving that it is making a difference in order to build a trustable brand, since that is the main incentive for investors.

When hedge funds take over a struggling company to improve its business and share price, their primary motivation is a big, and fast, return on their investment. Investors in the Engine No. 1 ETF won’t see outsize gains from their fund’s activism in any particular company—they’ll benefit as much as any other investor.

That’s partially why index funds have historically lacked the incentive to lead the ESG proxy fights, because they would pay all the costs, yet share the gains with competitors. But if investors begin choosing index funds based on how their investments are being used to make an impact, more asset managers might follow suit.

Write to Evie Liu at evie.liu@barrons.com