Fund Solutions

ESG Index Construction Key to Maximising ETF Returns – Sage 

ETF investors need to pay attention to index and third-party ESG data providers.  

Disparities have emerged in US ESG-themed exchange-traded funds (ETF) performance during a period of tremendous growth throughout 2020, according to investment management analysis and research firm Sage Advisory’s survey. 

In its ‘The Many Shades of ESG Integration: A Survey of US Equity ETFs’ report, Sage Advisory calls for investors to implement “a level of active risk management to ensure the ESG ETFs chosen are meeting a strategy’s risk / return profile”.  

The increase in ESG ETFs options investors should be increasingly specific about the values with which they align, otherwise “equal or better returns than a conventional fund […] can become harder to achieve,” the report warned.  

“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,” said Komson Silapachai, Sage Advisory’s Vice President of Research and Portfolio Strategy, and ESG Research Analyst Emma Harper, who co-authored the report.  

“Oftentimes, two funds with ESG’ in their names could have completely different sector exposures, integration methodologies, exclusions, and levels of concentration. The differences lie in the way they are constructed,” they continued. 

Sage Advisory analysis said US ESG ETF assets have grown to more than US$25 billion and the number of ESG ETFs has risen to 125 in 2020, compared to “a handful a few years ago” 

Case by case basis 

The vast majority (97%) of US equity ESG ETFs are passively managed, with MSCI proving to be the number one provider of indices in the market with US$21.8 billion in assets (87% market share). However, there are a wide variety of ways in which these indices have been constructed, which is why ESG ETFs do not inherently outperform or underperform the market, the report outlined. 

By assessing four US largecap core equity ESG ETFs, Sage Advisory concluded that they are typically constructed using various forms of negative screening. Nonetheless, their levels of security concentration vary. For example, the MSCI USA ESG Select features 157 names, compared to the S&P Global 500 ESG’s 299 names and MSCI Extended ESG Focus’s 300. 

“Those levels of concentrations along with other sector / style tilts result in higher expected tracking error versus a conventional benchmark,” the report said.  

Further analysis of the 24 largest ESG-optimised US equity ETFs “revealed a variety of risk and diversification considerations for investors”. The main point raised was the breadth of asset sizes in ETFs available, with a range of US$5.7 million to US$11.6 billion in AUM. The average AUM totalled just over US$1 billion as of October 2020.  

“These size differences suggest that investors should weigh the relative liquidity and trading costs associated with each of the ETFs because they can vary significantly depending upon the size and timing of potential transactions. This may also impact each of the ETFs’ relative performance and tracking efficiency over time,” Sage Advisory noted.  

Exclusionary ETFs 

Many of the largest US equity ESG ETFs include restrictions on certain industries widely considered to be “less ESG friendly”. Sage Advisory reported that 58% of assessed US equity ESG ETFs excluded nuclear energy from company selection, as well as 54% excluding fossil fuels and 83% excluding controversial weapons 

Excluding whole industries often leads to investors questioning how they can best achieve the level of diversification in their portfolio that is necessary for returns to outperform over time, Sage Advisory acknowledged 

For example, most of the tracking error expected from the MSCI USA ESG Leaders Index “comes from its underweight to the FAANMG (Facebook, Apple, Amazon, Netflix, Microsoft and Google)”, the report said. In comparison, the S&P 500 ESG and MSCI Extended ESG Focus indices have higher weightings in those stocks and therefore reduced tracking errors 

“Given the record market concentration in the largest-capitalisation technology stocks, this difference can have a big effect on financial outcomes.” 

Weighting differences in different ETF vehicles needs to be understood by asset allocators in order to construct a portfolio that aligns with the client’s dual objectives of returns and sustainability. By choosing to be underweight in FAANMG, an ETF might earn a higher ESG rating even if returns are more restricted, so it comes down to the personal preference of the investor. 

“The [most] important question [for investors] is, what type of risk relative to the conventional benchmark does one take on because of the ESG methodology implemented in a particular ETF?”  

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