The ESG ETF maze

18 June 2021

How can paraplanners help clients navigate an ESG ETF market proliferating with investment terms? Wayne Nutland, head of Managed Index Solutions, Premier Miton Investors, provides insight into this maze-like market

Funds and ETFs integrating Environmental, Social and Governance (ESG) factors into their investment process have seen tremendous growth in recent years, at times even showing growth whilst conventional funds and ETFs saw outflows. According to Bloomberg data, global equity ESG ETFs grew from around $80bn at the end of 2019 to $190bn at the end of 2020, and this growth has continued into 2021.

Clearly there is strong demand for investment solutions which integrate ESG considerations and it seems highly likely that this demand will continue given investor preference as well as regulatory changes encouraging the advancement of greener finance. Given their low costs and transparency, it seems that ETFs are well placed to capture flows into ESG investments.

However, ESG ETFs differ from conventional ETFs in several ways and it’s important that investors are aware of these differences before selecting an ESG ETF.

Generally speaking ETFs do what they say on the tin, but for some ESG ETFs it’s not immediately apparent what the words on the tin mean. Traditional ETF labels like ‘FTSE 100’ or ‘Small Cap’ or ‘Technology’ give a fairly good understanding of what’s inside the portfolio, but for ESG ETFs a bewildering array of terms has come into existence which require some work to translate what it says on the tin to an understanding of what’s inside the tin.

There are ETFs covering the US equity market with names including the following terms: ‘ESG’, ‘ESG Screened’, ‘ESG Universal Screened’, ‘Responsible Exclusions’, ‘ESG Universal Select’, ‘ESG Enhanced’, ‘ESG Leaders’, ‘ESG Trend Leaders’, ‘SRI’, ’Sustainable’, ‘Climate Change’, ‘Paris Aligned Climate’.

To some extent this proliferation of terms represents the ETF industry trying to take advantage of a new area which can be more differentiated than the more homogenised traditional ETF exposures. However mostly this array of terms represents the wide range of different approaches to ESG investment. To be clear, this is a welcome development as different investors have different approaches to ESG and want to integrate ESG into their portfolios in different ways, the wide array of offerings is catering to these different approaches. However this breadth brings complexity, and it’s important for investors to understand how the different ESG ETFs work.

Selecting an ESG ETF

In addition to the usual considerations like fees and structure, ESG ETF investors need to consider what type of ESG they require and how far from the standard asset class index they are prepared to go in order to achieve that ESG objective.

When considering what type of ESG is required, there are a range of different options which we could call ‘ESG intensity’. For example does the ESG approach exclude some businesses e.g. tobacco and arms, or does it exclude the lowest scoring businesses across all sectors? Alternatively does it select the best scoring businesses, and if so how many, the top 50%, the top 25%? Are there additional screens like removing companies associated with controversies or screens to reduce exposure to carbon emissions? Furthermore different ESG data providers can have different views on the same company, meaning that an ETF using MSCI’s ESG data can treat a company very differently to an ETF using FTSE ESG indices.

The second consideration is to assess the portfolio construction approach being taken by each ETF. An important question is how far the ETF differs from the main asset class index. Sticking with US equities, is the risk and return payoff likely to be broadly similar to US equities as represented by the S&P 500 for example, or could it be very different to the S&P 500? This is not to say that the conventional asset class index (in this case the S&P 500) represents the ideal portfolio, but the asset class index often represents an anchor for investor expectations and can act as an input into client risk profiling processes.

Again there is a range of approaches, some ETFs are designed to be broadly sector neutral, others employ quantitative techniques to limit the differences to the main asset class index. Others have fewer constraints, allowing the ESG criteria to determine the stock and sector make up. Again looking at US ESG ETFs, there are ETFs with more than 500 stocks and others with under 150. It’s important to remember that like all ETFs, an ESG ETF will track its official index and be compared to that official index on its factsheet. For ESG ETFs the official index is usually the ESG index, so performance compared to the main asset class index may not always be apparent.

To sum up, investors need to consider what type of ESG they require and how far from the standard asset class exposure are they prepared to go in order to achieve that ESG objective. There are no right or wrong answers here with solutions to fit different approaches to ESG and a range of investor tolerances for performance compared to the asset class. It’s also important to consider the investor’s wider portfolio, e.g. more ‘intense’ ESG ETFs may be preferred if held in a portfolio of standard index exposures, similar to a ‘core & satellite’ approach. Alternatively if the entire portfolio is to comprise ESG ETFs, then the investor may want to play closer attention to the overall differences compared to the main asset class indices.

This article was first published in the April 2021 issue of Professional Paraplanner.

Professional Paraplanner