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ESG ETFs Begin to Blur Boundaries

Actively managed ESG ETFs could offer investors the best of both worlds, but much remains to be done.

ESG-focused exchange-traded funds (ETFs) are proving to be an increasingly popular vehicle for investors looking for broad and cost-efficient exposure to assets with strong ESG credentials.

Demand for ETFs has grown over the past decade because they can track an index, sector, commodity or group of assets, while offering increased liquidity, transparency and lower risk in volatile markets. This is also the case for ESG-specific ETFs.

According to the Brown Brothers Harriman (BBH) 2021 Global ETF Investor Survey, 67% of European institutional and wholesale investors plan to increase their allocation to ESG ETFs over the next year, as well as 80% of US investors and 92% in Greater China.

In January 2021 alone, European ESG-themed ETFs attracted record net inflows of €8.6 billion, the second-largest monthly inflow to date, according to Lyxor Asset Management.

TrackInsight data shows that the best-performing ESG ETFs tend to be US-based, with nine out of 10 of the top performers. These include the Invesco WilderHill Clean Energy ETF, First Trust NASDAQ Clean Edge Green Energy Index Fund, First Trust NASDAQ Clean Edge Green Energy Index Fund and SPDR S&P Kensho Clean Power ETF.

With the Covid-19 pandemic raging, 2020 was a volatile year, and passive investment vehicles shone, according to Shawn McNinch, Global Head of ETF Services at BBH.

“The resiliency of the ETF structure and supporting capital market infrastructure saw them not only weather the storm but cement their status as a go-to option for investors to trade, especially in times of market stress,” he said.

In fact, ESG ETFs outperformed traditional ETFs.

A Morningstar analysis of the period of peak volatility in Q1 2020 found passive sustainable and ESG funds “weathered the market downturn” better than conventional ETFs in three of the four investment categories, noting that the Emerging Markets Large-Cap had the lowest proportion of outperforming ESG funds at under 30%.

Unsurprisingly, ESG ETF issuance has therefore grown at “an exponential rate during the past five years”, according to research and consulting firm Cerulli Associates. “Evidence that managing ESG risks can positively affect long-term performance is increasing and gaining wider acceptance among investors,” Cerulli noted in its ‘The Cerulli Edge – Global Edition’ report.

Active versus passive

Passive vehicles have increased market share by delivering superior (or at least comparable) returns at lower cost than actively-managed funds. But how well do ETFs help investors manage ESG risks and opportunities? And with investors increasingly looking to be more actively involved in the transition to a greener economy, are passive vehicles the best option?

While ETFs are lower risk, passive investment vehicles don’t lead the market so much as they react to it.

“In simple terms, active investors attempt to outperform the returns of a specific benchmark, whereas passive investors accept the market return by tracking a specific index,” Rathbones explained in a report.

For more pro-active ESG investors, passivity isn’t attractive, says Paulita Pike, Partner at law firm Ropes & Gray.

“If the investor wants to pursue a product that is in fact active in its ESG focus – meaning its looking to influence the portfolio companies in which it invests – that isn’t going to be so possible through a passive vehicle,” she adds.

Bob Jenkins, Global Head of Research at Refinitiv Lipper, describes ESG ETFs as a “blunt instrument approach” for investors.

For example, while they will generally steer clear of carbon-intensive energy, oil and gas companies and focus on securities with a low carbon footprint, they are designed to offer broad exposure. Comparatively, active funds are as specific as the fund manager wants them to be.

“You’re not going to find a massively dirty energy company in an ESG ETF because, for the most part, they tend to exclude them completely. Active managers often have a more focused list of securities that they cover in their ESG portfolios, making it easier to maintain an active dialogue with investee companies on ESG issues,” he says.

In order to drive performance, low-carbon ESG ETFs often choose to integrate tech stocks, Jenkins adds. Facebook, Google and Microsoft commonly feature due to their low carbon footprints, but social and governance issues mean that their overall ESG performance leaves much to be desired.

In investment management and research firm Sage Advisory’s ‘ESG Perspectives: Shades of ESG ETFs’ 2020 report, it was noted that “the primary reason there are so many ESG ETFs available today is that no industry-wide consensus exists about the right way to integrate ESG factors into a portfolio”.

In Europe, the introduction of Level 1 of the Sustainable Finance Disclosure Regulation (SFDR) this month – which asks asset managers to justify the green labelling of ESG products – is a key first step toward regulating ESG ETF products, the BBH report noted.

Beyond passive 

If ESG ETF providers want to attract more sustainability-focused investors, they can’t remain quite so passive, Sage Advisory emphasised. Instead, investors should implement “a level of active risk management to ensure the ESG ETFs chosen are meeting a strategy’s risk / return profile”.

But a more active due diligence process for investors can be “more onerous in terms of screening”, warns Antonette Kleiser, Product Manager for ETFs in Europe and Asia for BBH.

Fund managers who run ESG ETFs are sometimes investing in thousands of companies. “It can be challenging for them to deploy the resources necessary to properly assess and interact with each and every company, meaning passive fund managers with large amounts of stock holdings find it more challenging to support shareholder activist demands,” says Jenkins.

However, Francois Millet, Head of ETF Strategy, ESG and Innovation at Lyxor Asset Management, argues that ETF fund managers are “ideally placed with engage with underlying companies”.

“Investment decisions don’t get in the way of voting decisions – it’s the tracking of the overall index that matters – so the manager never leaves the table and can keep voting. This means that, as managers, we’re able to fully and freely support important issues, such as the fight against climate change, as we have an unconstrained ability to influence and improve corporate behaviour through voting,” he says.

Major ETF providers, such as State Street Global Advisors, BlackRock and Vanguard, may have that unconstrained ability to vote, but they have been pulled up on their unwillingness to vote against corporate management on ESG issues, potentially reflecting the challenges of engagement escalation in the absence of the ultimate sanction.

According to Sage Advisory’s annual ‘ETF Stewardship Survey’ report, only 50% of ETF provider respondents voted in opposition to management ballot proposals more than 10% of the time in 2020.

The logistical challenges of voting across multiple holdings may lead ETF providers to focus their energies on larger corporates defaulting to voting with management for smaller holdings.

“This poses a long-term concern for investors seeking managers that will strongly represent their stakeholder interests across all portfolio companies and demonstrate a willingness to take a more public stand through their respective votes on important corporate responsibility issues,” the report said.

From thematic to proactive 

One response to this problem of engagement and influence is the issuance of more concentrated thematic ESG ETFs, which allow investors to funnel investments into more specific ESG-related issues, while giving fund managers more tailored access to companies.

The BBH report highlighted that 80% of global investors plan to increase their allocation to thematic ETFs in 2021 – 81% of investors in the US, 86% in Greater China and 69% in Europe.

“The problem with thematic ESG ETFs is that it’s a bit like sector investing,” says Mark Fitzgerald, Head of Product Specialism at Vanguard Asset Management.

“If an investor tries to rotate between sectors in order to capitalise long-term returns, then they have to get their timing absolutely perfect. Thematic ESG ETFs leave investors open to theme-specific performance risks.”

Thematic ETFs diverge from a key strength of ETFs, which is broad and diverse exposure to the market, he explains. “The more specific you become with your requirements for ESG, the bigger the active risk,” Fitzgerald says.

To entice investors, ESG ETF providers are beginning to innovate.

“ETFs did used to be far more reactive,” Pike acknowledges, “but we’re starting to see an evolutionary shift. We’re starting to see more proactive products alongside reactive ones.”

Proactive ETF products are more responsive to the wider market, taking the initiative to react to events that may affect performance without waiting for the fund or indices they track.

For example, if a company within its holdings misses an emissions reduction target, the ESG ETF may choose to exclude it before the underlying fund or index.

“The liquidity of ETFs allows investors to get in and out due to being able to trade intraday,” Kleiser says.

But proactivity comes at a price. Transparency of all holdings 24/7 arguably gives investors immediate access to more decision-useful information, which allows them more control over their investments.

“The vast majority of ETFs will publish all of their holdings, and all of the weights of those holdings on a daily basis,” Simon Mott, Chief Marketing Officer for TrackInsight, explains. “If you’re an investor who wants to make sure your money is going into the right companies that are aligned with your sustainable targets, then that transparency is really useful.”

“Investors can peel back the onion to see how sustainable an ETF product is,” Kleiser agrees.

Active ESG ETFs make their mark

However, the next evolutionary stage of the ESG ETF also sacrifices transparency in exchange for outperformance.

Actively managed ESG ETFs remain affordable and broad, but also benefit from a fund manager actively trying to beat their benchmark (as opposed to replicating it), using discretion over what to buy or sell in order to outperform.

In the US, non-transparent, actively-managed ETFs are starting to hit the market.

As separate vehicles, ESG ETFs and active ETFs logged impressive performances in 2020, according to TrackInsight.

Active ETFs saw US$80 billion in net inflows over the course of the year, reaching US$273.5 billion in AUM – a total growth of 55%. ESG ETFs grew by 223% in 2020, reaching US$189 billion in AUM.

However, actively managed ESG ETFs have widely varying approaches, meaning the investor needs to make sure they are familiar with individual methodology and ESG criteria.

The American Century Sustainable Equity ETF – ESGA is an example of an actively managed ESG ETF. The fund doesn’t share with investors what assets it holds on a daily basis, but instead publishes a ‘Proxy Portfolio’ which outlines a small number of its top holdings.

This ESG ETF holds a broad range of sectors like IT, healthcare, communication services and more. However, its top holdings are notably dominated by tech, with the top four being Microsoft (6.89%), Apple (5.75%), Amazon (4.24%) and Alphabet (3.98%), as of March 16 2021.

Conversely, the BlackRock ESG Multi-Asset Conservative Portfolio UCITS ETF tracks existing ETFs, with the promise that at least 80% of its portfolio meets the fund’s ESG criteria.

The BMO Women in Leadership Fund (WOMN) ETF only invests in North American equities that have both or either 25% representation of women on the board of directors or a female CEO.

With no standardised model for actively managed ESG ETFs, there’s plenty of room for product innovation and investor involvement, Pike notes. The subgroup will likely continue to be refined over the coming months, straddling the boundary between passive and active investing, potentially incorporating the best of both worlds.

“As this space becomes more sophisticated, and as investors become more sophisticated within ESG, we will see this trend continue,” Pike says.

“We’re probably only in the first quarter of this journey – the so-called teenage years. There’s a lot more development and evolution to come.”

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