The latest Betashares/Investment Trends Insights report shows the vast majority (85%) of exchange-traded fund (ETF) investors think it’s important to invest in companies with good environmental and sustainability standards. Given such investor focus on the area, it’s no wonder ETFs with an emphasis on environmental, social and governance (ESG) attributes are a part of the market that’s rapidly changing.
According to ETF research house ETFGI, at 31 August 2019, there were 248 exchange-traded products (ETPs) with ESG traits, with more than US$40 billion in assets under management. Of these 55% are in Europe, 36% are in Asia Pacific and just 5% are in the US.
Meaghan Victor, head of SPDR ETFs Australia for State Street Global Advisors, says ESG ETFs are in demand as client needs have become more sophisticated and thanks to demand from younger investors.
“ESG approaches are increasingly important as money flows down to the millennial generation. When you consider more than 40% of Australian ETF investors are millennials, compared to just 12% five years ago, demand for ESG related products is likely to increase.”
Evan Reedman, Vanguard’s head of product, says the focus on companies’ sustainable economic health has aided momentum around ESG investing. “Regulatory change is also driving the adoption of ESG products by institutional investors.”
For instance, trustees in the UK are required to demonstrate sustainability in their approaches as part of their fiduciary responsibility to investors. In France, funds must publicly report their carbon footprint. Product disclosure statements in Australia have required information about ESG issues for many years now.
Reedman says ESG investments are becoming increasingly popular due to the emergence of common definitions about what ESG means. “This clarity can help investors choose the approach most aligned with their goals.”
Last year Vanguard launched the Vanguard Ethically Conscious International Shares ETF and the Vanguard Ethically Conscious Global Aggregate Bond ETF. The Vanguard Ethically Conscious International Shares Index Fund tracks the FTSE Developed ex Australia ex Non-Renewable Energy/Vice Products/Weapons Index, while the Vanguard Ethically Conscious Global Aggregate Bond ETF tracks the Bloomberg Barclays MSCI Global Aggregate ex SRI Exclusions Index.
Costs can vary widely among ESG products. There are a number of low-cost indexed products available, along with some, often actively-management strategies, carrying higher expense ratios.
Says Reedman: “Cost depends on the firm offering the product, its agreement with the benchmark provider that constructs the index and management expenses. ESG products are predominantly actively-managed, which typically involves higher cost.” He also notes ESG funds tend to be smaller. “Without scale, they may have a cost drag.”
Investment strategies that screen for ESG issues perform differently to the broader market because they exclude or include companies, which means they are generally overweight or underweight in some sectors, regions and factors.
“Investors should understand what they are investing in and the differences between products as they will drive the level of variation in returns when compared to the broad market,” says Reedman.
There’s no need for investors to give up returns just because they prefer to take a more responsible approach to investing. The Responsible Investment Association of Australasia’s benchmark report shows responsible investments have outperformed the market over one, five and ten years, with the S&P 300 only outperforming the average responsible investment fund over three years.
When it comes to product design, Nathan Lim, executive director, Morgan Stanley Wealth Management says negative screening naturally fits the ETF world. This is when funds exclude certain stocks or market sectors. By contrast, products that have a positive screen include certain sectors or stocks because they are perceived to have strong ESG credentials – renewable energy is an example.
“You can build pillars with ETF products that have negative screen. That’s a good way to start your portfolio journey. Then, if you want a positive impact and to contribute to social good, look for active managers creating positive outcomes. Morgan Stanley has an agnostic approach when it comes to active versus passive. You can marry a passive core with a negative screen with active managers tilted towards what you’re trying to achieve in terms of a social outcome,” Lim explains.
Wealth management businesses are also exploring ESG ETF innovations. Says Victor: “According to anecdotal feedback, in Australia licensees are looking to create an option within their model portfolios that is a full replacement of the ASX200 with an ESG function. Normally, it would be 5 per cent allocation to ESG – but now this is a like-for-like replacement.”
While greenwash ETFs – products marketed for green credentials that really just track the market – were a problem in the past, Lim says this is less of a concern now. “More managers and providers are taking a harder-nosed view and trying not to fall into this trap. The market has had a gut full of that. Investors are allergic to those products and providers, be they active or passive, have more integrity in their approach, which is good to see.”
Adam Verwey, Future Super founder and director, urges investors to do due diligence to make sure an ESG ETF isn’t greenwash. “Look into the institutions that are being invested in to make sure they match your definition of environmental, social and governance investing.”
Overall, investors are advised to be prudent when picking an ESG ETF. Victor suggests investors check whether the index reports holdings on a daily basis, whether it’s concentrated in particular sectors, companies or countries, as well as how many stocks or bonds are in the index.
She also suggests investors check the difference over time between the fund’s return and the index’s return, total cost of ownership, redemption fees, the ETF’s average daily volume and how it maintains liquidity.
When it comes to ESG ETFs, next year, Victor says more investors are likely to move from purely exclusionary to integrated ESG strategies, as well as investment strategies powered by multiple sources of ESG data.
“Growing demand to understand ESG performance against objectives will drive the need for enhanced reporting and climate solutions will evolve to include adaptation alongside mitigation. Overall, expect ESG to become increasingly mainstream, which should drive investment,” she says.