Fund Solutions

ETFs Boosted by Investors’ Long-term Sustainability Focus

Green passive instruments provide bright spot for managers despite uncertainty over SFDR status of PAB/CTR benchmark trackers.   

Despite short-term economic volatility, ESG exchange-traded fund (ETFs) 2022 flows in Europe increased, thanks to institutional investors’ growing focus on sustainability and a shifting regulatory landscape.  

According to ‘Q4 2022 European ETF Asset Flows’ published by data and research provider Morningstar, the overall European ETF and exchange-traded commodity (ETC) market closed last year with €78.4 billion in annual inflows, down from €160 billion in 2021. However, in a year when ESG “underperformed the mainstream”, the report noted that 65% (€51 billion) of total flows were directed to ESG products, up from 53% in 2021.  

“It was a terrible year all round [for the European passive market]. But institutional investors have largely been able to take the long-term view on ESG ETFs and dismiss short-term underperformance,” Jose Garcia-Zarate, Morningstar’s Associate Director of ETF Research, told ESG Investor. 

Assets in ESG investments increased to €248.8 billion last year from €235.5 billion in 2021, the report noted, representing 18.8% of total assets invested in ETFs and ETCs in Europe in 2022, an increase from 16.7% the previous year. If ETCs are excluded from the calculation, this goes up to 20.5%. 

“Investors are implementing long-term structural changes that are influencing their allocation of capital [in the passive market], prioritising sustainability, and this was really telling in the resulting ESG ETF flows,” Garcia-Zarate added.  

Climate-related goals are particularly important for pension funds adjusting their passive portfolios, according to a 2022 survey conducted by CREATE-research and sponsored by German asset manager DWS. 

Fifty-eight percent of large pension funds said they are in the process of embedding climate change goals in their passive portfolios, with 52% noting that the EU’s Paris-Aligned (PAB) and Climate Transition Benchmark (CTB) indices are “very important” as they tilt their portfolio to align with their net zero goals.  

Going into 2023, Garcia-Zarate expects to see demand for ESG ETFs continue to grow.  

“When I talk to European ETF providers, the vast majority of them say that their number one priority is to launch ESG-focused products going forward, because they recognise this is where most of the demand is.” 

Growing regulatory momentum  

The EU’s “clear regulatory direction” for sustainable finance has bolstered supply and demand of ESG passive products, said Garcia-Zarate. 

However, there is need for further clarity around Level 2 of the Sustainable Finance Disclosure Regulation (SFDR) for passive products, he noted.  

Level 2 went live on 1 January, and requires asset managers to provide detailed disclosures to justify the categorisation of their Article 8 (environmental and/or social characteristics) and 9 (environmental and/or social objectives) funds.  

However, it is currently unclear whether passive funds tracking the PAB or CTB can automatically be classified as Article 9. 

This is forcing asset managers to be more cautious, with some downgrading their funds, Garcia-Zarate said.  

DWS has said its ETFs would disclose in line with Article 8 instead of Article 9 until further clarity can be provided by the European Commission. 

“They want to test the waters and make sure they are fully in line with disclosure requirements,” he said. Once clarity is provided, they will “feel more comfortable upgrading their funds back to Article 9”. 

The practical information hub for asset owners looking to invest successfully and sustainably for the long term. As best practice evolves, we will share the news, insights and data to guide asset owners on their individual journey to ESG integration.

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